Mexican peso crisis

The 1994 Economic Crisis in Mexico, widely known as the Mexican peso crisis, was caused by the sudden devaluation of the Mexican peso in December 1994.

The impact of the Mexican economic crisis on the Southern Cone and Brazil was labeled the "Tequila Effect" (Spanish: Efecto Tequila).

Causes

The crisis is also known in Spanish as el error de diciembre — The December Mistake — a term coined by outgoing president Carlos Salinas de Gortari in reference to president Zedillo's sudden reversal of the former administration's policy of tight currency controls. While most analysts agree that devaluation was necessary for economic reasons, Salinas supporters argue that the process was mishandled on the political level.

The root causes of the crisis are usually attributed to Salinas de Gortari's policy decisions while in office, which ultimately strained the nation's finances. As in prior election cycles, a pre-election disposition to stimulate the economy, temporarily and unsustainably, led to post-election economic instability. There were concerns about the level and quality of credit extended by banks during the preceding low-interest rate period, as well as the standards for extending credit. The country's risk premium was affected by an armed rebellion in Chiapas, causing investors to be wary of investing their money in an unstable region. The Mexican government's finances and cash availability were further hampered by two decades of increasing spending, a period of hyperinflation from 1985 to 1993, debt loads, and low oil prices. Its ability to absorb shocks was hampered by its commitments to finance past spending.

Economists Hufbauer and Schott (2005) from the Institute for International Economics have commented on the macroeconomic policy mistakes that precipitated the crisis:

• 1994 was the last year of the sexenio, or 6-year administration of Carlos Salinas de Gortari who, following the PRI tradition on an election year, launched a high spending splurge and a high deficit.
• To finance the deficit (7% of GDP current account deficit), Salinas issued the Tesobonos, a type of debt instrument denominated in pesos but indexed to dollars.
• Mexico experienced lax banking or corrupt practices; moreover, some members of the Salinas family collected enormous illicit payoffs.
• The EZLN, an insurgent rebellion, officially declared war on the government on January 1; even though the armed conflict ended two weeks later, the grievances and petitions remained a cause of concern, especially amongst some investors.

Macroeconomics 5th Edition by N. Gregory Mankiw explains the country-risk issues precipitating the crisis:

• The EZLN's violent uprising in Chiapas in 1994 along with the assassination of presidential candidate Luis Donaldo Colosio made the nation's political future look less certain to investors, who then started placing a larger risk premium on Mexican assets.
• Mexico had a fixed exchange rate system that accepted pesos during the reaction of investors to a higher perceived country risk premium and paid out dollars. However, Mexico lacked sufficient foreign reserves to maintain the fixed exchange rate and was running out of dollars at the end of 1994. The peso then had to be allowed to devalue despite the government's previous assurances to the contrary, thereby scaring investors away and further raising its risk profile.
• When the government tried to roll over some of its debt that was coming due, investors were unwilling to buy the debt and default became one of few options.
• A crisis of confidence damaged the banking system, which in turn fed a vicious cycle further affecting investor confidence.

All of the above concerns, along with increasing current account deficit fostered by consumer binding and government spending, caused alarm among those who bought the tesobonos. The investors sold the tesobonos rapidly, depleting the already low central bank reserves. Given the fact that it was an election year, whose outcome might have changed as a result of a pre-election day economic downturn, Banco de México decided to buy Mexican Treasury Securities to maintain the monetary base, thus keeping the interest rates from rising. This caused an even bigger decline in the dollar reserves. However, nothing was done during the last five months of Salinas' administration. Some critics affirm this maintained Salinas' popularity, as he was seeking international support to become director general of the World Trade Organization. Zedillo took office on December 1, 1994.

A few days after a private meeting with major Mexican entrepreneurs, in which his administration asked them for their opinion of a planned devaluation; Zedillo announced his government would let the fixed rate band increase to 15 percent (up to 4 pesos per US dollar), by stopping the previous administration's measures to keep it at the previous fixed level. The government, being unable even to hold this line, decided to let it float.

The peso crashed under a floating regime from four pesos to the dollar to 7.2 to the dollar in the space of a week. The United States intervened rapidly, first by buying pesos in the open market, and then by granting assistance in the form of $50 billion in loan guarantees. The dollar stabilized at the rate of 6 pesos per dollar. By 1996, the economy was growing (peaked at 7% growth in 1999). In 1997, Mexico repaid, ahead of schedule, all US Treasury loans.

Financial assistance package

A week of intense currency crisis stabilized some time after the US President Clinton, in concert with international organizations, granted a loan to the Mexican government.

Loans and guarantees to Mexico totaled almost $50 billion, with the following contributions:

• The United States arranged currency swaps and loan guarantees with a $20 billion total value.
• The International Monetary Fund promised an 18 month Stand-by Credit Agreement of around US$17.7 billion.
• The Bank for International Settlements offered a $10 billion line of credit.
• The Bank of Canada offered short term swaps of around US$1 billion.

The Mexican "bailout" attracted criticism in Congress and the press for the central role of the former Co-Chairman of Goldman Sachs, U.S. Treasury Secretary Robert Rubin. Rubin used a Treasury Department account under his personal control to distribute $20 billion to bail out Mexican bonds, of which Goldman was a key holder. In late 1995, "[n]ewly installed President Ernesto Zedillo said he needed the cash to pay off bonds held by Citibank and Goldman Sachs, lest the New World Order come crashing down around the ears of its panicked acolytes." According to Hannibal Travis, the "former manager of $5 billion in Mexican investments at Goldman Sachs became U.S. Secretary of the Treasury and lobbied for legislation that forced U.S. taxpayers to contribute in excess of $20 billion to bail out investors in Mexican securities, in a form of 'corporate socialism'".

The United States' assistance was provided via the treasury's Exchange Stabilization Fund. This was slightly controversial, as President Bill Clinton tried and failed to pass the Mexican Stabilization Act through Congress. However, use of the ESF allowed the provision of funds without the approval of the legislative branch. At the end of the crisis, the U.S. actually made a $500 million profit on the loans.

See also

• Economy of Mexico
• Late 2000s recession
• 1998 Russian financial crisis
• Mexico
• North American Free Trade Agreement
• Sudden stop (economics)

External links

• The Mexican Economy 1996: Financial Assistance Package - Annual report of the Banco de México
• The Post-Nafta Mexican Peso Crisis: Bailout or Aid? Isolationism or Globalization? by Brett M. Humphrey
• Mindmapping for Economic Crisis of Mexico