1994 economic crisis in Mexico

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The 1994 economic crisis in Mexico, widely known as the Mexican peso crisis, was triggered by the sudden devaluation of the Mexican peso in the early days of the presidency of Ernesto Zedillo. A week or so of intense currency crisis was stabilized when US President Bill Clinton, in concert with international organizations granted Mexico a $50 billion loan.

The crisis is also known in Spanish as el error de diciembre — The December Mistake— a term coined by president Carlos Salinas de Gortari. In the Southern Cone and Brazil, the impact that the Mexican economic crisis had on the region was labeled the Tequila Effect (Spanish: Efecto Tequila).

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[edit] Effects of the economic crisis of 1994

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Mexican businesses with dollar outgoings were immediately affected. This included companies with dollar denominated debt and those reliant on US suppliers. There were massive industrial lay-offs and several well-publicized suicides. The country's GDP contracted approximately 7% in 1995-- the worst decline in the country's history in a single year.

[edit] Causes of the economic crisis of 1994

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While the crisis took place under President Zedillo, the causes are usually attributed to Carlos Salinas de Gortari's outgoing administration. Salinas de Gortari partly coined the term "December Mistake" when he stated in an interview that Zedillo's sudden reversal of the former administrative policies of tight currency controls was "a mistake." Salinas de Gortari's popularity and credibility at the time was still high. Even though his government's currency policy put an unbelievable strain on the nation's finances, the resulting economic bubble gave Mexico a prosperity not seen in a generation. This period of rapid growth coupled with low inflation prompted some political thinkers and the media to state that "Mexico was on the verge of becoming a First World nation.", and in fact, it was the first of the "newly industrialized nations" to be admitted into the OECD in May 1994.

As in prior election cycles, a pre-election disposition to stimulate the economy temporarily and unsustainably led to a self-fulfilling prophesy of post-election economic instability. Well before this, there were concerns about the sheer level and quality of credit extended by banks during the preceding low-interest rate period, as well as the standards for extending credit. Credit booms often precede credit busts. Later on, the country's risk premium was also affected by an armed rebellion in Chiapas which made investors even more 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, debt loads, and low oil prices. Its ability to absorb shocks was hampered by its commitments to finance past spending.

It was a known fact that the peso was overvalued (by at least 20%, according to some sources), but the extent of the Mexican economy's vulnerability was either not well-known or downplayed by Salinas de Gortari's tame políticos and media. Nonetheless, this vulnerability was further aggravated by several unexpected events and macroeconomic mistakes of his administration.

Economists Hufbauer and Schott (2005) have commented on several events in 1994, and 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 every election year, launched an amazingly high spending splurge, which translated into a historically high deficit
  • In order to finance the historical deficit (a 7% of GDP current account deficit) Salinas issued the Tesobonos, an attractive type of debt instrument that was denominated in pesos but indexed to dollars
  • Mexico experienced (common to those days) lax banking or corrupt practices; moreover, some members of the Salinas family (though only his brother, Raúl, was imprisoned) collected enormous illicit payoffs
  • The most-likely-to-win presidential candidate, Luis Donaldo Colosio, from the Institutional Revolutionary Party (PRI), was assassinated in March of that year; six months later, José Francisco Ruiz Massieu, who was secretary-general of the PRI, was assassinated as well
  • The EZLN, an insurgent rebellion, officially declared war on the government on 1 January; even though the armed conflict ended two weeks later, the grievances and petitions remained a cause of concern, especially amongst some investors.

All of these, along with the increasing current account deficit fostered by consumer binding and government spending, caused alarm amongst investors that had bought the tesobonos, mainly Mexican and a few foreigners, who sold them rapidly, depleting the already low central bank reserves. The economically orthodox thing to do, in order to maintain the fixed exchange rate functioning (at 3.3 pesos per dollar, within a variation band), would have been to sharply increase interest rates by allowing the monetary base to shrink, as dollars were being withdrawn from the reserves (Hufbauer & Schott, 2005). 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 in order to maintain the monetary base, and thus keep the interest rates from rising. This, in turn, caused an even more dramatic decline in the dollar reserves. These decisions aggravated the already delicate situation to the point where the crisis became inevitable and devaluation was only one of many necessary adjustments. However, nothing was done during the last 5 months of Salinas' administration even after the elections were held in July of that year. Some critics assume this was done in order to maintain Salinas' popularity, as he was seeking international support to become director general of the WTO. Zedillo took office on 1 December, 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 suddenly announced that 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 unorthodox measures to keep it at the previous fixed level (by selling dollars, assuming debt, and so on). It was no longer possible to maintain the previous fixed rate as reserves were on the brink of depletion (having hit a record low of merely 9 billion). This measure, however, was not enough. The government, being unable even to hold this line, decided to let it float. While experts agree that a devaluation was necessary, some critics of Zedillo's incumbent 22-day-old administration, argue that although economically coherent, the way it was handled was politically incorrect. By having announced its plans for devaluation, they argue that many foreigners withdrew their investments, thus aggravating the effects. Whether the effects were aggravated further or not, the result was that the peso crashed under a floating regime from four pesos to the dollar (with the previous increase of 15%) 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 that same year. [See the following section for a more detailed explanation.] The dollar then stabilized at the rate of 6 pesos per dollar. For the next two years, it remained around 7 to 7.7 pesos per dollar before being affected by the Asian Crisis in 1998.

As it had to comply with the recently signed NAFTA obligations, Mexico did not resort to the traditional Latin American policies in times of crisis of trade protection and capital controls (which might have prolonged the crisis), but introduced strict controls on monetary and fiscal policy, open trade, and devalued currency. The boom in exports that followed eased the recession, which had only lasted for ten months. By 1996, the economy was already growing (and peaked at 7% growth in 1999). In 1997, Mexico repaid, ahead of schedule, all US Treasury loans.

[edit] Financial assistance package

Mexican reserves continued to decrease into January 1995, raising the possibilities of peso inconvertibility, and international debt default. In view of the effects on Mexico's trading partners and the loss of confidence in Latin American economies in general, the IMF, the U.S. Government, and the Bank for International Settlements promised loans and guarantees to Mexico totalling almost $50 billion.

Contributions were as follows:

  • The United States arranged currency swaps and loan guarantees with a $20 billion total value.
  • The IMF 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 with a US dollar value of around one billion.

The United States' assistance was provided via the treasury's Exchange Stabilization Fund. This was a slightly controversial decision, as President Clinton had already 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 dollar profit on the loans.[1]

[edit] See also

[edit] References

  1. ^ Alan Greenspan (September 17, 2007). The Age of Turbulence. The Penguin Press, p. 159. ISBN 1594201315. 
  • HUFBAUER GC, J Schott, NAFTA Revisited: Achievements and Challenges, Institute for International Economics, Washington DC, October, 2005

[edit] External links

es:Crisis económica de México de 1994 fr:Crise économique mexicaine nl:Tequilacrisis sk:Ekonomická kríza v Mexiku (1994) vi:Khủng hoảng kinh tế Mexico 1994

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