Case Study: Mexican Peso Crisis, 1994

From 1954 to 1976, Mexico had maintained a fixed exchange rate of Ps12.50/$. Even after the collapse of the Bretton Woods fixed exchange rate system in 1971/73, Mexico was able to hold this fixed rate. Although the Mexican economy experienced rapid growth during most of the 1970s, it was progressively undermined by fiscal mismanagement in the form of large government borrowings (both home and abroad) which resulted in high rates of inflation and growing external indebtedness. As the international financial communitys concerns about Mexico grew, capital flight out of the country intensified. In response to this international crisis, the Mexican government was forced to end its regime of fixed exchange rates. On August 31, 1976, Mexico announced that it was switching to a managed floating exchange rate regime and devalued the peso by 45%. However, under this new arrangement, the Mexican authorities were still committed to intervening when necessary to maintain orderly conditions within a preset trading band for their currency. Difficulties continued for Mexico into the early 1980s. In the late 1970s, Mexico had borrowed billions of U.S. dollars at extremely high interest rates in anticipation of increased oil revenues. When the oil prices dropped sharply in the early 1980s, Mexicos oil revenues, and U.S. dollar revenues, plummeted as well. In 1982, Mexico was forced to default on billions of dollars of loans to foreign banks, mostly in the United States. The lack of confidence in the ability of the Mexican economy to rebound from this financial crisis led to high rates of inflation, a serious flight of capital out of the country, and a dramatic decline in the value of the peso. By 1983, the yearly inflation rate exceeded 110%. In the first six years of the 1980s, the value of the Mexican peso fell from around Ps50/$ to more than Ps1,100/$. The Mexican economy improved in the late 1980s and early 1990s. A series of price and wage control agreements signed by the government, labor unions, and private sector businesses in 1987 helped cut the inflation rate from 51 percent in 1988 to a low of 7 percent in 1994. Increased foreign trade and investment and a large-scale privatization of the country's state-owned companies helped the economy expand at a rate of more than 2.5 percent annually in the early 1990s. By the early 1990s, Mexico was being hailed as a champion of free-market reform. President Carlos Salinas, a Harvard-trained economist, was seen as turning Mexico away from the traditional inward-looking policies of other Latin American countries towards an outward-oriented, market-driven economy. In an effort to enhance Mexico's competitive profile, Salinas also undertook a campaign to privatize state industries and deregulate the private sector. Salinas

reduced foreign capital restrictions and took other steps to attract foreign investors, including cuts in public spending; as a result, the fiscal deficit was cut from 16 percent of GDP in 1987 to almost zero by 1994. As for the exchange rate regime, the peso was still being determined by a managed floating arrangement. In 1993, the government introduced a new Mexican Peso, whereby one new Peso would be equivalent to 1000 of the former Mexican Pesos. Between 1991 and 1993, more than $75 billion in foreign capital was funneled into Mexico, making it the world's second-largest recipient of foreign investment after China. The foreign capital which had flowed into Mexico in the early part of the decade was largely portfolio capital, i.e., investment in stocks and bonds rather than direct investment in plant and equipment. Unfortunately, this capital contributed little to the real Mexican economy. In addition, the Mexican banking system was beginning to show some serious weaknesses and as a result, non-performing loans piled up in Mexican banks. Thus, by late 1994, Mexico was again in trouble and the portfolio capital which had flooded into the country earlier, left the as quickly as it arrived. In response to the currency flight, and to relieve pressure on the peso, the government devalued the peso slightly, from Ps3.1/$ to Ps3.5/$. However, they decided to keep the currency band and to manage the currency within this band. However this time, the speculation was not to be halted. While the Mexican central bank had spent vast amounts of its reserves (by one estimate 85% of its reserves) trying to support the peso, it was become clear that little could be done to support the peso. On December 20, 1994, President Ernesto Zedillo expanded the currency band's range, effectively devaluing the peso by 15%. When this did not have the desired effect, he was forced, on December 22, 1994, to finally abandon the government's long-standing commitment to a managed float within a currency band, and allow the Mexican currency to float freely against the dollar. By the end of March 1995, the currency had fallen to around Ps7.0/$; this represented a depreciation of 100% in the currency.