Mexican Economy And Peso example essay topic

This paper argues that the Mexican peso crisis of December 20 should have been expected and foreseeable. In the year preceding the crisis, there were several indicators suggesting that the Mexican economy and peso were already under extreme pressure. The economy bubble was ballooning to burst so much so that it was simply a crisis waiting to happen. Evidences Signaling the Crisis 1. Decreasing Current Account Deficit versus Increasing Capital Account Balance Mexico was running an increasing current account deficit from US$7.5 billion in 1990 to US$23.4 billion in 1993.

This indicates an excess of private investing over private savings. However, the country was able to maintain an improving fiscal account from US$3.6 billion deficit in 1990 to US$0.7 billion surplus in 1993. The deficit in current account was financed through capital funds from abroad resulting the capital account to increase from US$8.4 billion in 1990 to US$33.8 billion in 1993. The over-dependent on foreign capital flows had made the Mexican economy very vulnerable to any sudden and major flux of this capital fund which was very much dependent on the investors' confidence level in the Mexican economy. The fact that majority of the capital funds was in the form of portfolio capital instead of foreign direct investment (FDI) had also worsen the situation.

The ratio of portfolio capital to FDI had increased substantially from 1: 1.3 in 1990 to 1: 6.5 in 1993. Given the volatile nature, portfolio capital tends to respond with greater speed to changes in the environment. 2. Depletion of International Reserve The central bank of Mexico has built up at high level of international reserve. The huge reserve was the result of the Mexican government's policy of exchange intervention to prevent large fluctuation in the peso. In the beginning of 1994, the reserve amounted to US$26.4 billion but was depleted to a low US$6.7 billion in Mid Dec, flagging red light that the exchange mechanism had been pushed to the limit and the government can no longer hold on to the pegged peso to US dollar.

3. Increasing Fed Rate but Decreasing Mexican Interest Rate Federal funds rate has risen the fifth time in 1994 on Nov 1994 and reaches 5.5%. This resulted in stronger dollar against peso as the quantity of US dollar reduced. This signaled problems for Mexico, which was highly dependent on foreign capital funds. There was in fact substantial drop in the flow of foreign equity investment since March 1994 after the assassination of Mr. Colosio. To counter the impact of federal fund rate increase on peso, Mexican government raised the domestic interest rate by selling more short-term government bonds.

The interest rate for peso-denominated c etes rose to 15.79% in April 1994 and increased to 17.07% in July 1994. However, in the second half of 1994, the Mexican government started to reduce the interest rate, contrary to the federal fund rate. Also, more of dollar-denominated were issued aggressively instead of peso-denominated c etes. This was likely due to investors being more willing to hold as they will be covered against the risks of devaluation and also lower interest rate for than c etes.

This was an indication that there was a loss in confidence for peso (i.e. people expected that the peso will devaluate to a point that even the differential in interest will not be able to cover and so were unwilling to hold on to peso-denominated bonds). 4. Declining Real GDP Growth The Mexico's inflation rate was really not in control as promised by the Mexican government. The Consumer Price Index was on the rise and real GDP growth has declined from 4.5% in 1990 to 0.6% in 1993. This shows that Mexico will experience more rapid inflation than United States in the coming year. This also means that Mexico peso will lose more value than US dollar during the year ahead.

Hence, there will be an increase in current demand for US dollar and hence, increase in value of US dollar relative to peso. A large proportion of Mexico's foreign direct investment was in "maquiladora" plants which value-added materials and parts imported from US and re-exported the assembled products to US. If value of US dollar continues to rise in relation to peso, this will mean that the imports of materials and parts in US dollar are more expensive and the re-export of assembled products in peso are cheaper. The value-adding component recognized in the current account will shrink further and hence, making it even harder for Mexico to service its substantial borrowings.

5. Political Instability Mexico was hit by a series of dramatic political crises in 1994. The unrest in the province of Chiapas on 1 Jan and the assassination of presidential candidate of the ruling PRI, Luis Donal do Colosio on 23 March and the Secretary of PRI, Partido Revolucionario Institutional, Jose Francisco Pui z Massieu on Sep 28 and also the scandal alleging a cover-up murder of the murder of Deputy Attorney General of Mexico, Mario Ruiz Massieu's brother. This high political drama undermined confidence in the political system and in the economy.

This has caused the international investors to take a cautious approach to committing more funds to Mexico. In fact, there were signs that the investors were already starting to withdraw funds from Mexico. There were generally a lack of trust among Mexicans and foreigners on the Mexican government's ability to maintain the value of the currency. The confidence level dropped even further from the political unrest's.

The investors were already very uptight. Just one signal will trigger the fear of devaluation and everyone will start rushing to leave. This was what happened on Dec 20 when the violence in Chiapas erupted again on Dec 19, following by the surprise announcement by government to increase the upper intervention limit for the peso by 15 percent. These were taken as signals that the new administration can no longer maintain the value of the peso and everyone started fleeing for safer heavens for money. Evidence in Mid-Dec for Major Government Policies Change Mexico's international reserve has been depleting and fallen by 50% in Mid Dec 1994 (US$6.7 billion) from Nov 1994's level (US$12.8 billion). This indicates that Mexican government can no longer hold on to the upper limit for long.

Given that US$11.6 billion was used up to support the peso after the assassination of Mr. Colosio in March 2004. With inadequate international reserve to cushion the impact of another political unrest, the government will be forced to raise the limit so as to release the pressure on the reserve. Why Investors Ignored this Evidence? If the evidence suggested that the peso crisis was imminent, why did the investors ignore this evidence?

The investors were misled by the below signals: 1. Optimistic Outlook Painted by Mexican Government Well aware of the importance of keeping the flow of capital funds and also under pressure of the election, the Mexican government had been painting an assuring picture that the situations were under control. It showed no sign of abandoning its strategy of economic reform and promised these investors that a policy that included "4 percent growth, low inflation and stable exchange rates" will be maintained. With the success of the Pac to, people had let down their guard and choose to believe in the government.

2. Bullish Mexico Stock Market The bullish capital market in 1994 had painted an over-optimistic picture of Mexico's real economic growth. Many of the investors were speculators who based their decisions on incomplete information and were merely following market sentiments (i.e. following the crowd). This explains the herd like response of investors on 20 Dec. 3. Entry to the NAFTA When the NAFTA came into force in Jan 1994, the share prices indices in Mexico jumped 17.5% from 388.6 points in Dec 1993 to 456.5 points in Jan 1994. This shows that the entry to NAFTA was viewed as an endorsement for continuous growth in the economy.

Also, the new administration had been expected to continue the economic policies. Therefore, investors were caught off-guard. 4. Information Disparity The public was not aware of the depleting international currency reserves. There seems to be an overwhelming of high profile optimistic reports on the Mexican economy from established sources: .

A World Bank report in Nov 1994 stated "Economic growth is expected to surge, reaching the highest level in five years, as a period of post election stability is anticipated". First JP Morgan and then Chemical Bank and then Swiss Bank argued in the fall of 1994 that Mexico's rating should be upgraded. Twelve major financial institutions out of twenty dismissed the possibility of a devaluation of the peso. According to Euromoney, Mexico's ranking among borrowing countries improved between March and September 1994 Conclusion The decreasing current account, increasing capital account, depleting international reserves, declining real GDP growth and increasing dollar-denominated all pointed towards the vulnerability of the Mexican economy.

In view of the repeated political unrest's, Mr. Woo and the others should have expected this crisis. But they based their decisions on surface information and market sentiments that had over-valued the market potential.

Bibliography

The Mexican Peso Crisis: the Foreseeable and the Surprise Nora Lustig, Brookings Institution, June 1995 Mexico 1994 versus Thailand 1997 Thailand Development Research Institute, 1997 Exchange-Rate Regimes, Speculative Attacks and Currency Crisis University of Essex An Early Warning System for Financial Crisis Dominic Barton, Roberto Newell and Gregory Wilson, Mc Kinsey & Company, 2003 The Impact of the Mexican Crisis of 94-95 on the Maquiladora Industry Paul Cooney, Queens College What NAFTA Brought to Mexicans? Jim Call is, March 1998.