1994 Mexican Peso Crisis - Essay Example

Introduction The 1994 Mexican Peso crisis was a monetary disaster that reverberated throughout the world. Brought on by Mexico's "Tequila Crisis" inwhich the country's current account deficit was seven percent of its gross domestic product and its foreign reserves dwindled, the peso's fixed exchange rate against the dollar "plunged by around 50% within six months. This in turn caused the local-currency value of the government's large dollar-linked debts to swell enormously and sent Mexico into a deep recession" ("Mexico finance," par. 1). Through the help of the United States and others, Mexico's economy has since rebounded nicely, but is not growing at a rate that many experts would consider desirable. To be sure, the scars of the 1994 crisis will be apparent in Mexico for years to come. NAFTA The impact of the currency crisis on Mexico's financial sector was especially severe. "Stacks of bad, even fraudulent, loans by the recently privatised banks were exposed. Many banks went bust. Thousands of Mexicans, particularly in the new middle class, defaulted on loans as interest rates rocketed, and had their homes repossessed. In 1995 GDP shrank by 6.2%" (par. 2). The devastation of this collapse had an impact that reverberated throughout the region, and was amplified by Mexico's recent ascension to the North American Free Trade Agreement (NAFTA). The new free trade block in North America demonstrated the ripple effect that a financial crisis in one country can have with its main trading partners. The existence of NAFTA, while a hazard to the United States due to this vulnerability to problems plaguing another country, constituted a life raft for Mexico because it ensured that the United States would need to make a greater effort than it otherwise might to assist Mexico. "President Bill Clinton reasoned that Mexico, then America's third-largest trading partner, must be helped because of its importance to American jobs and investment. His administration arranged a $40-billion standby loan--in the words of Robert Rubin, then the treasury secretary, not so much 'for the sake of Mexico, despite our special relationship, but to protect ourselves'" (par. 3). Nevertheless, it has been argued that NAFTA was one of the primary contributing factors to the currency crisis. Maskooki asserts that "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" (par. 12). Indeed, it is no accident that the currency collapse occurred within a few months of Mexico's ascension to NAFTA. Maskooki also notes that NAFTA ignored the need to coordinate economic cooperation among its members in light of Mexico's relatively primitive economic situation. "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 debtridden, archaic economy were little understood, and mostly ignored" (para. 10). Much more needed to be done to prepare Mexico for exposure to free trade such an advanced economy as that of the United States. The deregulation of the banking sector that was called for by NAFTA made Mexico's lack of preparedness quite evident. "NAFTA did not provide Mexican policy makers adequate time to assess the implications and ramifications of functioning in a freer market" (par. 9). It was essentially a very rushed trade agreement that was pressed forward more by the political considerations of its member countries than by any concrete economic calculations of its propriety. "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" (par. 9). Clearly, this factor could have and should have been foreseen by the experts who were assessing the likely ramifications of NAFTA. Other Causes of the Crisis The trigger for the Mexican currency crisis of 1994 was the decision by the three-week old administration of President Ernesto Zedillo to devalue the modestly devalue the peso by about fifteen percent "in order to supposedly better manage the nation's foreign reserves" (Sharma 59). This resulted in a speculative run against the peso as investors concluded that the peg to the U.S. dollar could not be sustained. "Despite the Central Bank's efforts to defend the peso, the panic stricken foreign financiers (including domestic investors), fearing a repetition of the 1982 debt crisis, rushed for the exit. In the ensuing stampede, Mexico lost over $5 billion in international reserves in less than two days, leaving it with only $3 billion in reserves" (60). Similar to the stock market crash that hit the U.S. in 1929 and precipitated the great depression, this panic among Mexican currency investors rippled throughout the economy and into the international arena. One of the factors contributing to the panic taking on crisis proportions was the decision of banks to stop lending in order to protect themselves. "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" (Maskooki, par. 3). The domino effect of these events was set off initially by the peso devaluation decision and culminated in a full-fledged assault on the nation's wealth. During the ensuing months, the crisis began to spill over into neighboring countries and was "threatening to engulf the entire region. Confronted with such a frightening prospect, the Clinton administration in conjunction with the International Monetary Fung (IMF), the World Bank, and the Inter-American Development Bank, hastily cobbled together an unprecedented $52 billion emergency bailout package to 'save' Mexico" (60). This bailout demonstrated the extent to which the world considered the crisis to be a threat. Essentially, as more and more Latin American countries became affected by the collapse of the Mexican currency, eventually causing the United States became threatened, the would took notice. An America weakened by international financial crisis was certainly a threat to the entire global economy. The Mexican currency crisis of 1994 came as a shock, largely because the Mexican economy had been performing so well it during the several years leading up to it that it had been described as the "Mexican Miracle." The administration of President Carlos Salinas de Gortari had pursued an aggressive market reform program in response to the economic problems that plagued the country in the early 1980s, such as "a crushing debt burden" and anemic growth in the GDP. The reform program emphasized "(a) opening the economy to international competition, (b) comprehensive privatization and deregulation of state-owned enterprises, (c) an economic stabilization program centered around a predetermined nominal exchange rate and backed by restrictive fiscal and monetary policies, and (d) a broad tripartite socioeconomic agreement . . . between the state, the private sector, and labor unions" (57). Such measures were a calculated attempt to modernize the Mexican economy and graduate Mexico from Third World to developed status. Salinas' market reforms, based on his "policy of fiscal restraint, a pegged exchange rate, and his strong anti-inflationary commitment," were a huge success by virtually every measure. GDP growth was an impressive 3.9% during the five years leading up to the crisis, inflation fell to single digit levels "for the first time in thirty years," and poverty levels were reduced from about twenty-five percent to twenty percent by 1993. In the early 1990s, Mexico also became a Mecca of foreign investment, receiving "roughly $104 billion . . . in net capital flows, or roughly one-fifth of all inflows to developing countries" (58). Finally, the public sector fiscal deficit as a percentage of GDP shrank from fifteen percent in 1987 to less than one percent in 1993. Essentially, "Mexico moved decisively away from a statist, import substitution model of economic development during the decade of the 1980s to a neoliberal export-oriented strategy" (Davis and Bartilow 134). These developments were a huge boost for a country that had economically struggled for so long. "Not surprisingly, as 1993 drew to a close, Mexico remained (as it had since the beginning of 1990) the toast of Wall Street" (Sharma 59). As a result of these economic advancements coupled with parallel political progress, "Mexico was seen as one of the best investments in the emerging markets" (59). The country's ascension to various international economic cooperative bodies, of which NAFTA was one, left many experts assuming that "if Mexico continued its robust economic growth, it would join the ranks of the most advanced nations within a decade" (59). In striking contrast to the years that would follow, "Mexico now stood vindicated, an exemplary success story and a model for others to emulate" (59). Arguably, this state of euphoria regarding the Mexican economy was a huge contributing factor to the disaster that followed. Overconfident and overly zealous investors, both foreign and domestic, became entrenched in Mexico, and then panicked at the slightest hint of financial volatility. Mexico's five year flirtation with economic greatness was an insufficient history upon which to judge the long-term stability of the country; and so investors did not know what to make of the Zedillo administration's move to modestly devalue the currency. The resulting crash was an all-too familiar result of an economic bubble, as was seen in the United States with the stock market crash of 1929 and the dot-com bubble burst of 2000. Many Mexicans, as well as outside observers, have strong opinions about who is ultimately to blame for the 1994 peso devaluation crisis. Some feel strongly that the policies of Carlos Salinas de Gortari set up an atmosphere of complacency and irrational exuberance resulting in an untenable economic bubble that would inevitably burst at some point. This line of thinking also maintains that Salinas put off the necessary devaluation in order to foist its ill-effects on his successor. Others fault Ernesto Zedillo for making a poorly timed devaluation call. Still others blame fickle investors who should not have become so easily panicked at what should have been an anticipated decision to devalue the peso. Ultimately, blame for the 1994 peso devaluation crisis could not be assigned to only one person. Like the perfect storm, an enormous confluence of events and circumstances came together in just the right way to produce the negative effects that transpired. The crisis "was generated in a highly complex global economy by policy decisions that involved both domestic and external actors. Domestic policies and decisions may have been the more immediate causes of the crisis, but it is important to understand these policies and decisions as reactions to Mexico's vulnerable position within a global capitalist economy, characterized by a high degree of interdependence and capital mobility" (Davis and Bartilow 137). There are myriad additional factors, both internal and external, that led to the crisis. These include several U.S. Federal Reserve interest rate hikes, assassination of a leading presidential candidate, and an armed rebellion in the Mexican state of Chiapas. "With no capital inflows, there was a huge loss of reserves. The confluence of these destabilizing factors, along with Mexico's weak economic fundamentals and its poor financial infrastructure, made risk adjusted return on peso assets too low and therefore peso-denominated assets became less attractive. Even though the Mexican central bank intervened in the foreign exchange market to strengthen the peso by raising interest rates sharply, it was unable to stop the stampede from peso to US dollar. The portfolio investment, being liquid and mobile, easily reversed the direction, leading to the peso devaluation" (Maskooki, par. 4). Clearly, the variable factors impacting Mexico were too much to bear, and the economic promise of the early 1990s was built on a house of cards. Recovery The aftermath of the Mexican currency crisis was severe, with real wages and stock prices taking nearly a decade to return to their pre-crisis levels. In 1995, the Mexican economy shrank by 6.2%, its largest decline since the Great Depression, with all sectors of the economy showing a severe down-turn (Davis and Bartilow 37). This constituted one of the most abrupt reversals of economic fortune of any country in history. Nevertheless, strict monetary and fiscal policies pursued by succeeding administrations have since resulted in inflation of around 5% and a current-account deficit at a "modest 1.4% of GDP" ("Mexico Finance" par. 5). While significant progress has been made in the recovery of Mexico from this financial turmoil, still more needs to be done. Mexico's potential growth rate is considered low for its present income levels and population growth rate. "Mexico's annual potential growth rate could be lifted above 6%. The country needs to improve education and infrastructure, and to increase competition in the business sector. Most urgent is the need to sharpen incentives for workers and firms to operate in the formal sector, where productivity is higher. At present relatively high social-security contributions deter the hiring of low-skilled workers with formal contracts" (par. 8). Conclusion The 1994 Mexican peso devaluation crisis was brought on by a confluence of several complex variables, some foreseeable and others not foreseeable. The economic progress that Mexico had made in the late 1980s and early 1990s, following a long period of stagnation and decline, made the crisis all the more shocking and unexpected. Mexico had been poised to join the ranks of the premier economies of the developed world before the sudden snap that caused the collapse. Coming to be known as the "Mexican Miracle," that country's economic rebound as a result of tight fiscal and macroeconomic policies, was the envy of the developing world. The causes of the collapse are too varied and complex to be thoroughly identified, although there are several key factors that conspired to bring about this unfortunate result, ranging from political to economic to social in nature. The decision of the young Zedillo administration to devalue the currency was certainly the trigger, but that alone would not have caused such a harsh reaction. Instability resulting from internal rebellion, lack of preparedness for a deregulated economic climate resulting from NAFTA, and a weak financial infrastructure were just a few of the factors that joined together to cause the crisis. Ultimately, the situation taught a stark lesson to the world about the devastating potential missteps and poorly timed fiscal decisions that are not adequately supported by the surrounding circumstances. References Davis, C., and H. Bartilow. "Attribution of Blame in the Global Economy: The Case of the Mexican Public and the Peso Devaluation Crisis." Mexican Studies 18 (2002):133-158. Maskooki, K. "Mexico's 1994 Peso Crisis and its Aftermath." European Business Review 14 (2002):161-170. "Mexico Finance: The Peso Crisis, Ten Years On." EUI ViewsWire 3 Jan. 2005. Sharma, S. "The Missed Lessons of the Mexican Peso Crisis." Challenge 44 (2001):56-89. Read More