Mexican peso crisis

thumb|261px|right|[[United States dollar|USD/MXN exchange rate]]

thumb|261px|right|Mexico inflation rate 1970-2022

The Mexican peso 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.

In the months leading up to the 1994 Mexican presidential election, the administration of incumbent president Carlos Salinas embarked on an 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 (NAFTA). 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 Bank of Mexico, the nation's central bank, intervened in the foreign exchange markets to maintain the Mexican peso's peg to the U.S. dollar by issuing dollar-denominated public debt to buy pesos. The peso's strength caused demand for imports to increase in Mexico, resulting in a trade deficit. Speculators recognized an overvalued peso and capital began flowing out of 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 time Ernesto Zedillo, the winner of that year's presidential election, was inaugurated in early December 1994.

In late December 1994, the Bank of Mexico devalued the peso, 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 merely hurt economic growth. Unable to sell new issues of public debt or efficiently purchase dollars with devalued pesos, Mexico faced a default. Two days later, the bank allowed the peso to float freely, after which it continued to depreciate. The Mexican economy experienced inflation of around 52% 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 (IMF) 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 poverty and unemployment increased.

Precursors

right|thumb|200px|Monument to Luis Donaldo Colosio in [[Mexico City's Paseo de la Reforma.]]

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 presidential candidate for his party, the Institutional Revolutionary Party's (PRI), in the general election. In accordance with party tradition during election years, Salinas began an unrecorded spending spree. Mexico's current account deficit grew to roughly 7% of GDP that same year, and Salinas allowed the Secretariat of Finance and Public Credit, Mexico's treasury, to issue short-term peso-denominated treasury bills 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 their dollar-denominated returns were more attractive to foreign investors.

thumb|left|250px|Zapatista Army of National Liberation (EZLN) insurgents in Mexico.

Investor confidence rose after the North American Free Trade Agreement (NAFTA) was signed. Upon NAFTA's entry into force on January 1, 1994, Mexican businesses as well as the Mexican government enjoyed access to new foreign capital thanks to foreign investors eager to lend more money. That year Chase Manhattan Bank alone held an estimated $1.5 billion in Mexican securities. International perceptions of the country'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. Higher risk premia initially had no effect on the peso's value because Mexico had a fixed exchange rate.

Banco de México, the central bank, 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. They then used the borrowed dollar capital to purchase pesos in the foreign exchange market, which, in turn, caused the peso to appreciate. The bank's purpose in mitigating the peso's depreciation was to protect against inflationary risks of having a markedly weaker domestic currency, but 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. Speculators began recognizing that the peso was artificially overvalued and led to speculative capital flight that further reinforced downward market pressure on the peso. Consistent with the macroeconomic trilemma in which a country with a fixed exchange rate and free flow of financial capital sacrifices monetary policy autonomy, the central bank's interventions to revalue the peso caused Mexico's money supply to contract (without an exchange rate peg, the currency would have been allowed to depreciate). The central bank's foreign exchange reserves began to dwindle and it completely ran out of U.S. dollars in December 1994. The impact of Mexico's crisis in Chile and Brazil became known as the "Tequila effect" ().

Bailout

In January 1995, U.S. President Bill Clinton held a meeting with newly confirmed U.S. Treasury Secretary Robert Rubin, U.S. Federal Reserve Chairman Alan Greenspan and then-Under Secretary for the Treasury Larry Summers to discuss an American response. According to Summers' recollection of the meeting:

<blockquote> Secretary Rubin set the stage for it briefly. Then, as was his way, he turned to someone else, namely me, to explain the situation in more detail and our proposal. And I said that I felt that was required, and one of the President’s political advisers said, “Larry, you mean .” And I said, “No, I mean .” ... There was a certain pall over the room, and one of his [Clinton's] other political advisers said, “Mr. President, if you send that money to Mexico and it doesn’t come back before 1996, you won’t be coming back after 1996.”</blockquote>

Clinton decided nevertheless to seek Congressional approval for a bailout and began working with Summers to secure commitments from Congress.

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 in January 1995, to be administered by the IMF with support from the G7 and the Bank for International Settlements (BIS). The package established loan guarantees for Mexican public debt 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 bailout's success in preventing a worse collapse. Growth did not resume until the late 1990s.

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.

Following the U.S. Congress's failure to pass the Mexican Stabilization Act, the Clinton administration reluctantly approved an initially dismissed proposal to designate funds from the U.S. Treasury's Exchange Stabilization Fund as loan guarantees for Mexico. These loans returned a profit of $600 million and were even repaid ahead of maturity.

Economic impacts

Mexico's 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, revealing low-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.

thumb|left|330x330px|Construction workers working on a residential building in Tijuana, Mexico.

In addition to declining GDP growth, Mexico experienced severe inflation and extreme poverty skyrocketed as real wages plummeted and unemployment nearly doubled. Prices increased by 35% in 1995. Nominal wages were sustained, but real wages fell 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 people lost their jobs and average real wages 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, undoing the previous ten years of successful poverty reduction initiatives. The nation's poverty levels would not begin returning to normal until 2001.

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, access to credit, and 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.

References

External links

Economic Unrest in Mexico from the Dean Peter Krogh Foreign Affairs Digital Archives