Mexican peso crisis
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|History of Mexico|
The Mexican peso crisis (also known as the Tequila crisis or December mistake crisis) was a currency crisis sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994, which became one of the first international financial crises ignited by capital flight.:50–52 During the 1994 presidential election, the incumbent administration embarked on expansionary fiscal and monetary policy. The Mexican treasury began issuing short-term debt instruments denominated in domestic currency with a guaranteed repayment in U.S. dollars, attracting foreign investors. Mexico enjoyed investor confidence and new access to international capital following its signing of the North American Free Trade Agreement. However, a violent uprising in the state of Chiapas, as well as the assassination of the presidential candidate Luis Donaldo Colosio, resulted in political instability, causing investors to place an increased risk premium on Mexican assets.
In response, the Mexican central bank intervened in the foreign exchange markets to maintain the Mexican peso's peg to the U.S. dollar. Its strategy involved issuing dollar-denominated public debt to buy pesos. The peso's strength caused demand for imports to increase, resulting in a trade deficit. Speculators recognized an overvalued peso and capital began flowing from Mexico to the United States, increasing downward market pressure on the peso. Under election pressures, Mexico purchased its own treasury securities to maintain its money supply and avert rising interest rates, drawing down the bank's dollar reserves. Supporting the money supply by buying more dollar-denominated debt while simultaneously honoring such debt depleted the bank's reserves by the end of 1994.
The central bank devalued the peso on December 20 and foreign investors' fear led to an even higher risk premium. To discourage the resulting capital flight, the bank raised interest rates, but higher costs of borrowing negatively affected economic growth. Unable to sell new issues of public debt or efficiently purchase dollars with devalued pesos, Mexico began facing a default. Two days later, the bank allowed the peso to float freely, after which it continued to depreciate. The Mexican economy experienced hyperinflation of around 52 percent and mutual funds began liquidating Mexican assets as well as emerging market assets in general. The effects spread to economies in Asia and the rest of Latin America. The United States organized a $50 billion bailout for Mexico in January 1995, administered by the International Monetary Fund with the support of the G7 and Bank for International Settlements. In the aftermath of the crisis, several of Mexico's banks collapsed amidst widespread mortgage defaults. The Mexican economy experienced a severe recession and saw rising poverty and unemployment rates.
With 1994 being the final year of his administration's sexenio (the country's six-year executive term limit), then-President Carlos Salinas de Gortari endorsed Luis Donaldo Colosio as the Institutional Revolutionary Party's (PRI) presidential candidate for the Mexico's 1994 general election. In accordance with party tradition during election years, Salinas de Gortari began an unrecorded spending spree. Mexico's current account deficit had grown to roughly 7% of GDP that same year, and Salinas de Gortari allowed the Secretariat of Finance and Public Credit (Mexico's treasury) to issue short-term treasury bills denominated in pesos with a guaranteed repayment denominated in U.S. dollars, called tesobonos. These bills offered a lower yield than Mexico's traditional peso-denominated treasury bills, called cetes, but were more attractive to foreign investors due to the dollar-denominated returns.:8–10:14
Foreign investors' confidence in Mexico's economy rose following the signing of the North American Free Trade Agreement (NAFTA) by Canada, Mexico, and the United States. Upon its entry into force on January 1, 1994, Mexican businesses as well as the Mexican government enjoyed access to new foreign capital as outside investors became eager to lend more money. International perceptions of Mexico's political risk began to shift however, when the Zapatista Army of National Liberation declared war on the Mexican government and began a violent insurrection in Chiapas. Investors further questioned Mexico's political uncertainties and stability when PRI presidential candidate Luis Donaldo Colosio was assassinated while campaigning in Tijuana in March 1994, and began setting higher risk premia on Mexican financial assets. The higher risk premia initially had no effect on the peso's value due to Mexico's fixed exchange rate regime.:375
Mexico's central bank, Banco de México, maintained the peso's value through an exchange rate peg to the U.S. dollar, allowing the peso to appreciate or depreciate against the dollar within a narrow band. To accomplish this, the central bank would frequently intervene in the open markets and buy or sell pesos to maintain the peg. The central bank's intervention strategy partly involved issuing new short-term public debt instruments denominated in U.S. dollars, then using the borrowed dollar capital to purchase pesos in the foreign exchange market, thereby causing its value to appreciate. The bank's aim in mitigating the peso's depreciation was to protect against inflationary risks of having a markedly weaker domestic currency. With the peso stronger than it ought to have been, domestic businesses and consumers began purchasing increasingly more imports, and Mexico began running a large trade deficit.:179–180 Speculators in Mexico began recognizing that the peso was artificially overvalued and started investing in U.S. assets in anticipation of its demise. Intending to exchange dollars for pesos later on at an advantageous exchange rate, the capital flows from Mexico to the United States resulting from speculative capital flight actually strengthened downward market pressure on the peso.:179–180
Mexico's central bank deviated from standard central banking policy when supporting a fixed exchange rate. Normally, a country's central bank would allow its monetary base to decrease and its interest rates to rise. Rather, Mexico purchased treasury bills to support its monetary base in an effort to prevent rising interest rates, motivated by the political pressures of an election year. Additionally, servicing the tesobonos with U.S. dollar repayments further drew down the central bank's foreign exchange reserves.:8–10:375:451–452 Consistent with the macroeconomic trilemma in which a country with a fixed exchange rate and free flow of financial capital sacrifices its monetary policy autonomy, the central bank's interventions to raise the value of the peso by purchasing pesos with dollars against increasing downward market pressure caused Mexico's money supply to contract (whereas without an exchange rate peg, the currency would have instead been allowed to depreciate). The central bank's foreign exchange reserves began depleting as a result of its continuous purchases of pesos until it ran out of U.S. dollars completely in December 1994.:375
On December 20, 1994, newly inaugurated President Ernesto Zedillo announced the Mexican central bank's devaluation of the peso between 13 and 15 percent.:50:10:179–180 Devaluing the peso after previous promises not to do so led investors to be skeptical of policymakers and fearful of additional devaluations. Investors flocked to foreign investments and placed even higher risk premia on domestic assets. This increase in risk premia placed additional upward market pressure on Mexican interest rates as well as downward market pressure on the Mexican peso.:375 Foreign investors anticipating further currency devaluations began rapidly withdrawing capital from Mexican investments and selling off shares of stock as the Mexican Stock Exchange plummeted. To discourage such capital flight, particularly from debt instruments, the Mexican central bank raised interest rates. To the bank's dismay, the higher borrowing costs ultimately hindered economic growth prospects.:179–180
When the time came for Mexico to rollover its maturing debt obligations, few investors were interested in purchasing new issues of public debt.:375 To repay tesobonos, the central bank had little choice but to purchase dollars with its severely weakened pesos, which proved extremely expensive.:179–180 The Mexican government faced an imminent sovereign default.:375
On December 22, the Mexican government allowed the peso to float, after which the peso depreciated another 15 percent.:179–180 The value of the Mexican peso depreciated roughly 50 percent from 3.4 to 7.2 pesos per U.S. dollar, recovering only to 5.8 MXN/USD four months later. Prices in Mexico rose by 24 percent over the same four months, and by the end of 1995 Mexico's hyperinflation reached 52 percent.:10 Mutual funds which had invested in over $45 billion worth of Mexican assets in the several years leading up to the crisis began liquidating their positions in Mexico and other developing countries. As foreign investors persisted in fleeing not only Mexican securities, but emerging market investments in general, the Mexican peso crisis's contagious effects quickly spread to other financial markets in Asia and Latin America.:50 The impact of Mexico's crisis on the Southern Cone and Brazil became known as the Tequila effect (Spanish: efecto tequila).
Motivated to deter a potential surge in illegal immigration and to mitigate the spread of investors' lack of confidence in Mexico to other developing countries, the United States coordinated a $50 billion bailout package for the Mexican government in January 1995 to be administered by the International Monetary Fund (IMF) with the support of the other G7 member nations and the Bank for International Settlements (BIS). The package established loan guarantees for Mexican public debt securities, aimed at alleviating its growing risk premia and boosting investor confidence in its economy. The Mexican economy experienced a severe recession and the peso's value deteriorated substantially despite the success of the bailout package in preventing a worse collapse. Overall income would not resume growth until the late 1990s.:52:10:376
The conditionality of the bailout package required the Mexican government to institute new monetary and fiscal policy controls, although the country refrained from historical balance of payments reforms such as trade protectionism and strict capital controls to avoid violating its commitments under NAFTA. The loan guarantees enabled Mexico to restructure its short-term public debt and improve market liquidity.:10–11 Of the approximately $50 billion USD assembled in the bailout package, $20 billion was contributed by the United States, $17.8 billion by the IMF, $10 billion by the BIS, $1 billion by a consortium of Latin American nations, and $1 billion CAD by Canada.:20
The Clinton administration's efforts to organize a bailout for Mexico were met with difficulty. It drew criticism from members of the U.S. Congress as well as scrutiny from the news media.:52 The administration's position centered on three principal concerns: potential unemployment in the U.S. in the event Mexico would have to reduce its imports of U.S. goods (at the time, Mexico was the third largest consumer of U.S. exports); political instability and violent rioting in a bordering neighbor country; and a potential surge in illegal immigration from Mexico. Some congressional representatives agreed with American economist and former Chairman of the U.S. Federal Deposit Insurance Corporation, L. William Seidman's arguments that Mexico should resolve its crisis through negotiation with its creditors without involvement by the United States, especially in the interest of deterring moral hazard. Others in support of involvement, including then-Chair of the Federal Reserve Alan Greenspan, argued that the fallout from a Mexican sovereign default would be so devastating that it would far exceed the risks of moral hazard.:16
Following congress's failure to pass the Mexican Stabilization Act and with the Mexican crisis deteriorating, the Clinton administration reluctantly approved a previously dismissed proposal to designate funds from the U.S. Treasury's Exchange Stabilization Fund as loan guarantees for Mexico.:159 All of the loans contributed by the U.S. Treasury returned a profit of approximately $600 million after being repaid ahead of maturity.:10–11 Then-U.S. Treasury Secretary Robert Rubin's appropriation of funds from the Exchange Stabilization Fund in support of the Mexican bailout was scrutinized by the United States House Committee on Financial Services. The committee expressed concerns about a potential conflict of interest based on Rubin's former service as Co-Chairman of the board of directors for Goldman Sachs, an investment bank which offers a substantial volume of Mexican stocks and bonds.
The Mexican economy experienced a severe recession as a result of the peso's devaluation and the flight to safer investments. The country's GDP declined by 6.2% over the course of 1995. Mexico's financial sector bore the brunt of the crisis as banks collapsed, illuminating the existence of poor quality assets and fraudulent lending practices. Thousands of mortgages went into default as Mexican citizens struggled to keep pace with rising interest rates, resulting in widespread repossession of houses.
In addition to Mexico's decline in GDP growth, it experienced hyperinflation and rapid growth in extreme poverty as real wages plummeted and unemployment nearly doubled. Prices in the Mexican economy increased by 35% in 1995. Although nominal wages sustained, the effects of hyperinflation resulted in real wages falling by 25-35% over the same year. Unemployment climbed to 7.4% in 1995 from its pre-crisis level of 3.9% in 1994. In the formal sector alone, over one million citizens lost their jobs and average real wages in the sector decreased by 13.5% throughout 1995. Overall household incomes plummeted by 30% in the same year. Mexico's extreme poverty grew to 37% in 1996 from 21% in 1994, unwinding the previous 10 years' successful poverty-reduction efforts. The nation's poverty levels would not begin returning to normal until 2001.:10
Mexico's growing poverty affected urban areas more intensely than rural areas, in part due to the urban population's sensitivity to labor market volatility and macroeconomic conditions. Urban citizens relied on a healthy labor market, good access to credit, and on consumer goods. Consumer price inflation and a tightening credit market during the crisis proved challenging for urban workers, while rural households shifted to subsistence agriculture to provide for their needs.:11 Mexico's gross income per capita decreased by only 17% in agriculture, contrasted with 48% in the financial sector and 35% in the construction and commerce industries. Average household consumption declined by 15% from 1995 to 1996 with a shift in composition toward essential goods. Households saved less income and spent less money on healthcare services. Expatriates living in other countries such as the United States increased remittances to Mexican households, evidenced by average net unilateral transfers from abroad doubling from 1994 to 1996.:15–17
Households' lower demand for primary healthcare resulted in mortality rates climbing to 7% in 1996 from 5% in 1995 among infants and children. This reversed the previous downward trend in infant mortality prior to 1994, which did not resume until 1997. Mortality rates increased most dramatically in regions of Mexico where women entered the workforce as a result of economic need.:21–22
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