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The situation that arose in Mexico in 1995 after the devaluation of the peso by 15% sent the currency into a downward spiral over the succeeding months in what became known as the Mexican Peso Crisis. A currency crisis is defined by a sharp and unexpected decrease in the value of the currency. This was precisely the case in Mexico, losing over 60% of its value in less than four months. The drastic nature of the crisis came as a surprise to many because of the unprecedented success of the Mexican economy in the years before. Mexico had curbed its inflation, posted very impressive growth rates, and was reaping the global benefits of the imminent North American Free Trade Agreement. It certainly looked as if this historically unstable nation made a stand to become just the opposite, a country that stressed political and economic stability and strength. The seeds of the crisis had been planted in the form of policies, actions, and events that created an increasingly vulnerable economy and disaster was on the horizon. The following paper will examine both the causes and effects of the Mexican Peso Crisis of 1994. First, we must look back to the presidential term of Carlos Salinas and the policy actions that were undertaken in the early 1990s up through the months before the crisis. The growing state of vulnerability that the economy was subjected to was a direct result of decisions made during his term and the short term speculative investment during the same time. Secondly, we must be informed of the very

unfavorable Mexican political climate in the months preceding the 1994 elections. Investor faith in Mexico declined drastically before the actual election due to both endogenous and exogenous economic factors. Then, the handling of the deteriorating economic situation and the devaluation of the peso by the new President, Ernesto Zedillo, which brought the country into the murky depths of a currency crisis shall be discussed.

And finally, the speedy recovery of the Mexican economy due to successful policy changes and bailout loans from the International Monetary Fund and their northern neighbor, the United States of America, will wrap up the assessment of the Mexican economic situation that engulfed the country in the early to mid 1990s. In the conclusion, I will discuss whether or not the crisis could have been avoided. The Salinas Presidency Mexico had historically adopted highly protectionist economic policies, but when Carlos Salinas became the countrys leader, he enacted a series of reforms that would liberalize the Mexican economy. His plan was to liberalize financial and trade markets, eliminate the fiscal sizable fiscal deficit, and pursue a strict monetary policy and rigid exchange rate policy that brought Mexicos high rate of inflation under control. It seems as if Mexico was on the right track in the undertaking of these structural reforms, but the costs certainly outweighed the benefits. It was the combination of these factors that led to such a vulnerable economy (Heath). One major problem was the dramatic increase in the extension of credit to the private sector as the government turned their fiscal deficit of 16% of GDP in 1987 to a surplus of 2% of GDP in 1991. Not only were businesses able to access this credit but the middle class Mexican was also taking advantage of this. This extension of credit aided in expanding businesses, as well as taking out loans on homes and other durable goods. The new option of credit resulted in large increases in consumption and a huge reduction in the savings rate (Heath). Along with this came a reduction in tariffs, which made imports much cheaper. Mexicans were buying imported consumer goods at an extremely rapid pace as a result of the liberalization of financial and trade markets.

The Mexican government began to increase their borrowing from abroad to finance their deficit in the current account, which was increasing annually as a result of the consumption boom. As we know, this is a similar situation as the one in the United States. Our government balances out our tremendous current account deficit with an equal amount of capital inflows from abroad. The one fundamental difference is the type of capital inflows that enter the country. The USA is a favorable place to invest because of its preeminent position in the global economy. Much of the investment is secure in the country for years to come. In Mexico, the opposite was the case. The inflows were mostly speculative and short term in nature, again increasing the vulnerability of the economy. In this case, capital flight would prove to be a disaster, especially in a fixed exchange rate system (Heath). In terms of exchange rate policies, the government consulted the officials of business and labor and worked out an agreement, known as the Pacto, which could be renewed or changed when deemed necessary. The Pacto was instituted in order to curb the inflation that had reached triple digits in years past. The agreement completely eliminated any flexibility of the peso. The policy helped to lower inflation to 7% in

1994. The stability that the Pacto seemed to offer led to a huge increase in investor confidence because the interest rate was also stable in such a system and the government was in control of the rate. It would be in their best interest to maintain it. This is how the traditionally undervalued peso became overvalued. The exchange rate remained

constant in a Mexican economy that had increased import growth and falling inflation. Because the rate had no flexibility, the ever-increasing current account deficit was

maintained because imports were still very cheap and speculative capital inflows were financing it (OECD 1995). The Pacto policy kept the peso artificially overvalued. NAFTA was also a major player in policy decisions made by the Mexican government in the early 1990s. The government enacted both restrictive monetary and fiscal policy in order to slow down the economy in 1992. They took such action because any doubt surrounding NAFTAs ratification would cause investor shakiness and capital flight (Heath). This policy slowed down the growth rate of the economy and lessened the current account deficit. But in 1994, an election year, the political agenda of Salinas overshadowed his relatively successful economic policies. His advisors pushed through an expansionary economic policy, both monetary and fiscal. The government became increasingly confident in NAFTA and the possibility of increasing foreign direct investment, which would finance an increasing current account deficit that would come about by stimulating aggregate demand coupled with the appreciated peso. With the expansionary policies in full effect for the election year, the Mexican economy saw a rapid increase in the second quarter of 1994 in government spending, private investment, and the consumption of durable goods. GDP growth skyrocketed from 2.3% in the first quarter to 5.6% in the second quarter. This can be explained by the extension of credit from the central bank to development banks, followed by increased borrowing by Mexican businesses and households. In 1994, despite the expansion of the economy, a decidedly violent time of political unrest came about. The Zapatista uprising started it all in Chiapas in January. From there, there stemmed a series of kidnappings, resignations, and assassinations of prominent officials of government. On top of this, interest rates across the globe began to

increase, especially in the United States. As a result, global investment was on the decline due to unfavorable interest rates. The leading presidential candidate for the PRI, the party of Salinas, was assassinated in March. This led to increased investor wariness and intense capital flight. In the month after this murder, over $10 Billion in foreign reserves fled Mexico. The Salinas government responded with what some call expansionary monetary policy and an overhaul of the bond market. The policy that was enacted was a

substitution of sorts. The money that was rapidly retreating from Mexico was in a sense offset by the expansion of the credit system. In a country so set on fixing the rate of exchange, this policy is certainly questionable and hardly restrictive. The government also substituted tesebonos for cetes. The latter is a Mexican T-bill and the former is a dollar-dominated bond that offers a guaranteed exchange rate at expiration. Investors responded by transferring billions of dollars from cetes to the tesebonos. This seems to have been another political move by Salinas and his finance minister, Pedro Aspe, in order to save votes. Ernesto Zedillo and the Crisis The PRI won the election of 1994 with the help of the policies put forth at the end of the Salinas campaign. However, instead of paving the way for President Zedillo and the new finance minister, Jaime Serra, the outgoing officials set up a pretty sizable roadblock. It is completely obvious that the incoming government was unprepared to handle the economic situation (Kleinberg). Both fiscal and monetary policy needed to be tightened in order to achieve a soft landing because the economy was growing at a pace it could not sustain and the peso was still overappreciated (Heath). By now the

vulnerabilities in the Mexican economy were known to pretty much everyone except the Zedillo government. I suppose that is why they refused to change any aspect of

economic policy when coming to office. Foreign investors continued to pull out after this announcement, leaving Mexico with a mere $10.4 Billion in foreign reserves. Mexico found itself in a tight spot. Finally, the Pacto met and decided to devalue the currency by 15%. They felt that this would be a sufficient adjustment. The main flaw in their thinking was ignoring the fact that further structural reforms were still needed in monetary and fiscal policy (Kleinberg). With no other reforms mentioned, investor confidence reached an all time low. In the day, December 22, following this announcement, the foreign reserves fell by $4.5 Billion, almost 50% of the total. From that day, the peso was a member of the

freely floating exchange rate club. The peso continued to depreciate to 60% of pre-crisis levels in March of 1995. Along with this currency free fall came a free falling stock market that lost 40% of its value, setting it back almost two years and acutely increasing interest rates. There was also the issue of debt, especially in the short term. The aforementioned tesebonos were coming due in the near future to the tune of $30 Billion, which would throw Mexico into a further state of turmoil if international aid did not arrive soon. In January of 1995, the government offered a plan to restructure economic policy by tightening monetary and fiscal policy and an emergency aid package of $18 Billion was put together by the IMF and countries across the globe. Even the combination of these two plans could not restore the broken investor confidence, and the peso kept on depreciating. Both the banks and the government came under intense scrutiny in regards

to paying off debts by investors, who feared defaults. Mexican economy lasted until the beginning of March. The Recovery of the Mexican Economy

The downward spiral of the

Mexico was the recipient of a huge emergency package spearheaded by the IMF and the United States of America. The total amount reached $52 Billion, enough to roll over its short-term debt. Clearly, the international community was intent on ameliorating the Mexican situation, as evidenced by the sufficient total. On top of the aid, the Mexican government responded with a more complete stabilization plan and the peso began to appreciate. Fortunately for Mexico, this crisis could not have happened at a better time because the 1990s was one of the greatest decades for growth on a global scale ever. The recession of 1995 was the consequence of the peso crisis of the prior year. With high debt in the private sector and very little inflowing capital, the domestic demand that increased so greatly under Salinas shifted back and poverty increased. Large businesses were able to absorb the negative affects of recession by capitalizing on their weak export prices and the overall increase in global demand. But 1995 was a rebuilding year, one to correct the mistakes of the past structural reforms. In terms of fiscal policy, the government decided to tighten through a 50% increase in the VAT and an increase in energy prices. The government also planned to cut spending by 10% in real terms by reducing staff, instituting hiring freezes, and postponing new infrastructure projects. On monetary policy, the government tightened in order to restore some stability to the peso and by reducing the credit ceiling of central bank domestic credit (OECD 1995). Both proved to be successful in light of the succeeding years.

Mexico handled the crisis quite well, especially when looking at the structural reforms that minimized a recession to one year. GDP fell by 6.9% in 1995 but bounced back in a big way in 1996, growing 5.1% and then grew by 6.8% in 1997 (OECD 1995). They have experienced record levels of foreign direct investment, which is almost twice as high as the current account deficit. The debts have been restructured and are

serviceable. The peso has seemed to regain its competitiveness in the wake of the crisis, continuing to increase their more affordable exports. The Mexican people have turned their backs to the PRI (and hopefully currency crises), which maintained power for over seven decades and voted in Vicente Fox in 2000. Avoidable or Not? The question often arises in some economic circles as to whether or no the Mexican Peso Crisis of 1994 was avoidable or inevitable. I have come to the conclusion that it was definitely avoidable and could have been prevented during both the Salinas and Zedillo presidencies. It is clear to me that if the political agenda of Salinas did not stand in the way of improving Mexico and the slow actions of the incoming Zedillo cabinet were carried out with more stealth, then the crisis may have never happened. In the first case, the Salinas government stood strong by the Pacto system and never took the opportunity to devalue the peso. The currency was overvalued and the economy could not sustain its level of consumption. On top of that, the foreign The consequence, as

investment was speculative and unstable in its own right.

previously stated, was a highly vulnerable economy. During the political uprisings and debacles of 1994 that led to the first wave of capital flight, the government probably should have abandoned their exchange rate policy and devalued, as well as changing their

expansionist stance. The government made the wrong decision in increasing the credit base of banks and issuing tesebonos. Both of these actions intensified the fragility of the economy in the coming months. It gave the Mexican people a false sense of security. Devaluing at that time would have relieved Mexico and its banks of the debt burden that plagued them in 1995. In this case, an attempt at a soft landing may have prevented the currency crisis. With respect to the Zedillo administration, the investor skepticism that carried over from the previous policies and events was magnified to a great degree with the hesitation of the government. First of all, they took control after a series of very sketchy political crimes and were certainly under the world microscope because off their unstable and relatively recent national heritage. Devaluing the currency and tightening monetary and fiscal policy at this point would have let the world know that Mexico had a handle on its economic matters. Since they acted with a great deal of uncertainty, the investors did as well. Mexico was repeatedly damaged by the political decisions in 1994 and suffered the through the turmoil and recovery of a currency crisis which could have been avoided.

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Bibliography: Gordon, Robert. Macroeconomics. Eighth Edition, Addison-Wesley, Reading, MA, 2000. Heath, Jonathon. Mexico and the Sexenio Curse: Presidential Successions and Economic Crises in Modern Mexico. CSIS Press, Washington, D.C., 1999. Kleinberg, Remonda. Strategic Alliances and Other Deals: State-Business Relations and Economic Reform in Mexico. Carolina Academic Press, Durham, NC, 1999. OECD Economic Surveys: Mexico 1994-1995. Paris, France, 1995. OECD Economic Surveys: Mexico 1996-1997. Paris, France, 1997 Roett, Riordan, ed. The Mexican Peso Crisis: International Perspectives. Lynne Rienner Publishers, Boulder, CO, 1996.