Mexico Peso Crisis - Causes, Impact, And Response

What went Wrong for Mexico in 1994?

Discuss about the Mexico Peso Crisis.

In the period early 1990’s the economy of Mexico seemed very healthy. The country was recovering after the lost decade of 1980’s. The decade of 1980’s was lost to debt crisis of 1982 and also the steep fall in oil prices during 1986. The economy as stated earlier, in early 1990’s seemed pretty healthy as inflation had reduced substantially, the foreign investors were pumping money into the country and the reserves of the central bank were soaring in billions. Coupled with favorable economic situation, the proposal to reduce trade barrier with biggest trading partner United States also led to foreign fund inflows. The agreement to reduce trade barriers were finally passed when the agreement took place through North American Free Trade Agreement (NAFTA) in the year 1994 (Boughton, 2012).

However less than 12 months the country was facing economic disaster. In the month of December, 1994, the government had to devalue its currency namely peso. The financial crisis which took place led to very high inflation and pushed the economy into a severe recession (Boughton, 2012). So what is this currency crisis which led to such a drastic change in the economy? What were the possible reasons which led to such an economic disaster? In this paper we will look at all the aspects which lead to crisis and will also look at the steps which were taken to come out of the crisis period. 

Passing of NAFTA, coupled with strong economic situation was a favorable situation for Mexico. The reforms taken by the Government such as restructuring of foreign debts, reduction in budget deficits and privatization of government entities also made the situation more favorable. One of the biggest problem which occurred in Mexico was the overheating of the economy in a situation when the currency was tightly controlled. However the currency was not ready to face the heat of opening up of the economy.

Mexico had a crawling pegging related exchange rate system. Under this system the government intervention insured that the exchange rate traded in a narrow band of the target rate, however the band was raised slightly every day to allow gradual depreciation of peso. However on the counter side the in real terms the peso was appreciating, which was the main reason for the high current account deficit. The current account deficit increased to $20 billion in 1993 compared to $6 billion in 1989 (Gandolfi, 2014).

Exchange Rate System of Mexico

The first set of shock started when there was a political rebellion in the province of Chiapas. This raised serious doubts about the political stability of Mexico. The political rebellion which occurred against the ruling party raised concern about the political stability of the country. However the initial reaction to this rebellion didn’t led to capital flight from Mexico. Later a much more severe political shock took place when the presidential candidate of the ruling party, Luis Donaldo Colosio was assassinated on March 23^rd, 1994. He was considered to be the one who will lead the country post the next elections. This created a financial panic as investors withdrew fund due to political instability. As we can see from the below graph, the reserves of the currency depleted during this period as government had to intervene heavily to maintain the value of peso. As per the Central bank of Mexico estimates, Mexico lost $11 billion as reserves during one month (Boughton, 2012).

As the peso depreciated sharply, the interest rate in Mexico started rising sharply. After the assassination of the political leader, the interest rate in Mexico 28 day cetes averaged 16.4% in the month of May, 1994 compared to 9.5% of the same paper in February, 1994. The sharp rise in interest rate was signs of the fact that people were charging hefty interest to support peso’s valuation. The confidence in the economy has shaken post the development of political instability (Kemme, 2016).

Some other factors which dented the investor confidence during the same period were resignation of few ministers, kidnapping of a prominent businessman. All these factors combined together contributed to market jitters which in short term hurt the market badly. After the kidnapping of the prominent businessman of Mexico, the reserves fell by $2.5 billion dollars in period of three weeks (Gandolfi, 2014). The exchange rate were already at the top level of the target band rate and hence it was not depreciating further.

The final nail in the coffin was placed in the system when Deputy Attorney General Mario Ruíz Massieu, brother of assassinated president made some huge accusations and finally resigned from his post. He made claims which targeted important people of the ruling party, stating that they were behind the assassinations of his brother. He further went on to say that these were the people who were also obstructing all kind of investigations in the matter. Such huge disarray and fights among the top government officials of Mexico dented investor confidence (Boughton, 2012).

Rise of Political Instability

The biggest external shock which hit the economy of Mexico during 1994 was the rise of Interest rate in its biggest trade partner United States. The Federal Reserve of United States raised its fed rate target in the month of February, 1994. This happened for the first time since the recession of 1990-91. The Federal fund rate increased to 5.5% in late November which was substantial increase of 300 bps from the low in the year 1993. The rise in fed target rate also lead to substantial jump in long term interest rate in the United States. Mexico policymakers responded to the same using some temporary measure and did not take any concrete policy level changes. The balance of payment situation started worsening with the rise of Interest rate in the economy(Turk, 2013).

The financial meltdown hit Mexico big time. However a question which has been asked for last 20 years is whether the devaluation was unavoidable. The current account deficit was increasing quarter over quarter for Mexico as the peso was considered to be overvalued. The current account deficit situation of the country was indicative of the fact that currency needed devaluation. Senior economists in the country has given enough indication from early 1993 that there is a need to bring peso’s value to its real level (Kemme, 2016). However the Government paid no heed to it and the Current Account Deficit continued rising and as a result reserves kept depleting. So on 20^th December, 1994, Central Bank of the country devalued peso and as a result of fear among investors, the risk premium for the country rose sharply.

The devaluation of the peso and the resultant increase in the risk premium led to sharp capital flight from the country. To arrest the capital flight, the Central Bank of Mexico raised the interest rate. The rise in interest rate increased the cost of borrowing and hence hurt the growth in the economy. Since the investors feared investing in the country, Mexico was not able to place its debt in the market. As a result of this they didn’t had dollars to serve the debt and faced default. The economy faced hyperinflation and mutual funds across nations started liquidating their holdings. After 2 days of havoc in the economy, Mexico allowed peso to free float in the market from December 22, 1994. This saw further depreciation in the value of peso (McNamara, 2015).

Rising of Interest Rates in Mexico

The moment the crisis shaped up in Mexico, mutual funds across the world started liquidating their holdings from other developing nations. Most of the funds left the emerging markets and the crisis created a contagion as it reached markets of Asia and Latin America. This often historically is referred to as tequila effect. In a globalized scenario it has been seen that fund movement is so interlinked. This is termed as tequila effect.  Major mutual funds across the world started withdrawing money from the countries where risk premium was comparatively higher. This as a result created a panic among such markets and many currency crisis which stemmed later in these economies often find their route from this crisis. Let’s say the East Asian currency crisis which came to forefront in 1996 also finds it route from the capital flight which started post the peso crisis (Kemme, 2016).

United States was the biggest trade partner to Mexico and the country also felt the heat of the crisis in the big way. Finally President Clinton decided to intervene and planned a bailout for Mexico to the tune of $50 billion which was to be administered by International Monetary Fund (IMF). This was also supported by G7 countries. The objective of the bailout was to increase the investor confidence in the Mexican economy and hence reducing the risk premia that the investors were commanding from the country. The bailout came with a condition which desired that Mexico need to implement strong market related fiscal and monetary controls. The country still refrained from balance of payment related reforms but ultimately it led to free floated currency (Kemme, 2016).

There were severe economic impact of the whole series of event on Mexican Economy. The economy went into recession, it didn’t recovered till the early parts of next decade. The country’s GDP declined sharply and the financial sector faced the maximum brunt. Many of the big banks collapsed as low quality assets led to high provision requirement and ultimately banks went belly up. Thousands of mortgages across the countries were not repaid as citizens of the country couldn’t keep pace with the rising interest rate. Mexico also faced a period of hyperinflation, high unemployment and poverty also rose in the country (Turk, 2013).

Conclusion

The Mexico currency crisis is a classic example of how things can go from good to worse if short terms measures are used to plug problems. The Mexico was growing at a fast pace but the fact that country kept the currency rate pegged for long, didn’t implemented structural reforms resulted in ultimate collapse of the market. The economy as stated earlier, in early 1990’s seemed pretty healthy as inflation had reduced substantially, the foreign investors were pumping money into the country and the reserves of the central bank were soaring in billions. Coupled with favorable economic situation, the proposal to reduce trade barrier with biggest trading partner United States also led to foreign fund inflows (Kemme, 2016). The recovery in such cases can be very long and a generation of people in the country completely lose the means to live. In the globalized world how situation spread fast to all markets was also visible in the crisis. The markets similar to Mexico, which faced the same risk premia saw a sharp capital flight. This resulted in crashing markets and economies facing huge problem. The country’s GDP declined sharply and the financial sector faced the maximum brunt. Many of the big banks collapsed as low quality assets led to high provision requirement and ultimately banks went belly up (Kemme, 2016). One can learn from such instances that long term market reforms need to be implemented for market development. In the short run when economies witness momentum, it is important structural reforms and controls are not compromised (McNamara, 2015).

References

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Gandolfi, D., Halliday, T., & Robertson, R. (2014). Globalization and Wage Convergence: Mexico  and the United States.

Kemme, D. M., & Koleyni, K. (2016). Exchange Rate Regimes and Welfare Losses from Foreign Crises: The Impact of the US Financial Crisis on Mexico. Review of International Economics.

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Lustig, N., Lopez-Calva, L. F., & Ortiz-Juarez, E. (2013). Declining inequality in Latin America in the 2000s: the cases of Argentina, Brazil, and Mexico. World Development, 44, 129-141.

McNamara, C., Rhee, J., & Metrick, A. (2015). Restructuring and Forgiveness in Financial Crises  A: The Mexican Peso Crisis of 1994-1995. Yale Program on Financial Stability Case study.

Monras, J. (2015). Immigration and wage dynamics: Evidence from the mexican peso crisis.

Refalo, J., Fang, H., Yi, J., & Nath, G. C. (2012). Investor perceptions and equity-sovereign bond return correlation: revisiting the Mexican Peso Crisis. Macroeconomics and Finance in Emerging Market Economies, 5(1), 78-93.

Turk, J. M. (2013). Mexico: The Balance of Payments during the 1994 Financial Crisis and Beyond.

Valenzuela, C. M. (2014). Petroleum Hypothecation: Consequences for Mexico in Latin America since the Peso Crisis. Asian Journal of Latin American Studies, 27(2), 47-73.

Watkins, K., Van Dijk, D., & Spronk, J. (2015). Corporate Governance and performance during the  aftermath of the 1994 Mexican crisis. EconoQuantum, 2(2).