Economics Update (July-December 1996)
Economics Update (July-December 1996)
A Predictable and Avoidable
In the first of two articles examining the Mexican crisis, Atlanta Fed economist Joseph A. Whitt Jr. argues that the Mexican financial crisis of 1994-95 was foreseeable. Large short-term liabilities, a pegged but overvalued exchange rate, and a continuing current account deficit should have provided ample warnings of the coming disaster. Had the government acted decisively to correct these deficiencies, he says, the crisis could likely have been avoided. For more expanded discussions see the January/February 1996 issue of the Atlanta Fed's Economic Review (available on the world-wide web at http://www.frbatlanta.org)
s 1993 drew to a close, Mexican prospects appeared good. The enactment of the North American Free Trade Agreement (NAFTA) culminated a series of reforms undertaken during the administration of President Carlos Salinas. To many observers, the only sign of trouble was Mexico's current account deficit, which ballooned from $6 billion in 1989 to more than $20 billion in 1992 and 1993.
Just a year later, in December 1994, the peso was devalued and a severe financial crisis ensued. Mexico's central bank blamed the crisis on a series of political shocks that occurred during 1994: the rebellion in Chiapas and the March 23 assassination of the ruling party's presidential candidate, Luis Donaldo Colosio (Salinas' expected successor).
Despite these tremors, Ernesto Zedillo (Colosio's replacement) was elected president in August. But by December 1, 1994when Zedillo took officethe economic situation was precarious. Reserves were down to about $12.5 billion (from $25 billion at the end of 1993), and the government faced more than this amount in short-term liabilities. Foreigners were holding about $25 billion in government securities, 70 percent dollar-denominated. For the third consecutive year, the current account deficit was over $20 billion, and most forecasters did not expect much improvement in 1995. In addition, the exchange rate was close to the top of its target band against the dollar (see Chart 1).
Sterilization fueled the fire
The Mexican government and others insisted that the current account deficit was not a concern because it was caused by private capital inflows that were financing investment spending, not by fiscal deficits or excessive monetary expansion. In reality, a large portion of the capital inflows went into short-term financial investments, such as bank deposits and short-term government bonds (see Chart 2). Also, while the current and capital accounts moved together in the early 1990s, in 1994 capital inflows dropped dramatically as the current account deficit widened. As a fraction of gross domestic product (GDP), the current account deficit rose from 2.8 percent in 1989 to an average of more than 7 percent between 1992 and 1994.
Even as the current account deficit widened, the growth of Mexican reserves (until early 1994) reinforced the government's false sense of security. Between 1990 and 1993, the central bank accumulated international reserves while reducing domestic credit. This policy, called "sterilizing" (matching central bank purchases of international reserves with sales of government bonds from its portfolio), prevents a rise in the monetary base and an expansion of the money supply. By the end of 1993 Mexico's international reserves totaled $25 billion, roughly four times their level at year-end 1989.
Mexico's central bank justified its sterilization on the basis that without it monetary expansion would have led to inflationary pressures. However, sterilization tends to keep domestic interest rates high, encouraging continued capital inflow. Moreover, in countries such as Mexico, where long-term bond markets are not well developed, sterilization through open-market operations can be done only with short-term instruments, thus biasing the capital inflows toward very short maturities. When Mexican reserves peaked in 1993, Mexico's ratio of highly liquid government and bank liabilities was at least four times the size of net international reserves, the highest ratio in Latin America.
A policy of avoidance
In 1994 the U.S. Federal Reserve inadvertently added to Mexico's woes. Concerned that U.S. inflationary pressures were building, the Fed raised its federal funds rate target several times, reaching 5.5 percent by late November, a substantial increase from 1993's prevailing 3 percent. Other rates followed the funds rate.
Despite the economic and political shocks, Mexican policymakers continued massive sterilized intervention and avoided major changes in monetary or exchange-rate policy. The government also changed the composition of its debt, issuing large amounts of a short-term, dollar-denominated security called tesobonos. Over the next few months, the government converted a considerable portion of its debts into tesobonos. By November 1994, 70 percent of foreign holdings of Mexican government securities were in tesobonos.
By this time, with its dollar reserves dwindling, the government's policy options were limited: supporting the existing exchange rate by tightening monetary policy severely, floating the peso, or devaluation. On December 20 the government chose a 15 percent devaluation. In a best-case scenario, public confidence would have remained high enough to prevent a speculative attack on the new peg. However, the announcement of devaluation jolted public confidence, and diminished Mexican reserves added to the climate of vulnerability.
Muted initial market reaction to devaluation
Curiously, initial market reaction to the devaluation was generally positive. The government announced the devaluation before markets opened on December 20. The regular weekly auction of tesobonos occurred later that day and went quite well: average yield was 8.61 percent, only 38 basis points (bp) above the previous week's auction. The amount sold was $416 million, about the same as in the previous week.
The following day, the regular weekly auction of cetes was held. It too went reasonably well: average yield was 16.22 percent, up 142bp from the previous week. However, nervous investors shifted funds out of Mexico, resulting in a loss of $4.5 billion in reserves, the largest single-day decline of the year. On December 22, with reserves less than $6 billion, the government announced that it was abandoning the exchange rate target band and allowing the peso to float.
Market sentiment turned. At the next tesobono auction (December 27) the amount bid totaled only $28 million. The average yield was 10.23 percent, up about 1.5 percentage points from the previous week. The next cetes auction also went poorly: the amount bid fell well below the amount offered, as well as below the amount sold a week earlier, and the average yield soared to 31.41 percent, up 15 percentage points from the previous week. By the end of December the peso had depreciated to Ps5.3 per dollar, 35 percent below its value a month earlier.
As the Mexican government's access to credit dried up, market participants increasingly worried about the large quantity of tesobonos due to mature in 1995. Nearly $10 billion worth of tesobonos was slated to mature in the first quarter of 1995, and another $19 billion was due to mature before the end of the year.
The contrast between the severe market reaction to the move to a floating peso and the relatively mild response to the initial devaluation suggests that Mexico might have been better off increasing the target band's rate of crawl and making an earlier decision to devalue while reserves were still high enough to stave off at least a modest speculative attack on the peso.
In the weeks following the devaluation the U.S. and other governments made several efforts to help Mexico resolve the crisis. On January 2, 1995, an $18 billion line of credit was committed, half by the U.S. government and half by other governments and a few large private banks.
However, investors remained reluctant to roll over Mexican debt, primarily because the credit line was smaller than the amount of tesobonos maturing in the next few months. At the next two tesobono auctions, Mexico sold only small amounts (less than 20 percent of the amounts sold at the two auctions in December prior to the devaluation), even though it was offering higher and higher interest rates: the average yield at auction on January 10, 1995, was 19.63 percent.
On January 12 the Clinton administration proposed a larger assistance package, totaling $40 billion in loan guarantees. The proposal initially buoyed the financial markets, but it soon became clear that the U.S. Congress would be reluctant to approve it.
By January 31 the situation was desperate: Mexico needed quick cash to avoid default, but congressional approval of the $40 billion loan-guarantee package was nowhere in sight. At this point, the Clinton administration proposed a direct-loan package that included $20 billion from the United States and $18 billion from the International Monetary Fund (IMF), plus about $13 billion from the Bank for International Settlements (a quasi-governmental institution controlled by a consortium of central banks) and other commercial banks. In order to avoid a special congressional vote authorizing the assistance, the U.S. contribution was taken from the Exchange Stabilization Fund (ESF).
However, even following President Clinton's decision to tap the ESF, market participants remained extremely wary of Mexican debt. The tesobono auction on February 7 resulted in an average yield of 21 percent. The peso continued to weaken, bottoming out at Ps7.45 per dollar, until Mexico announced a stringent economic austerity package in early March.
Lingering effects, but quicker recovery
While Mexico's devaluation came as a surprise to many, there were signs that a crisis might be brewing. It seems likely that by early 1994 the peso was overvalued; the question was whether the overvaluation could be corrected without setting off a financial crisis that would set back Mexico's development for months, if not years. For months the government tried to avoid decisive action by maintaining the exchange rate peg while leaving other elements of policy largely unchanged. In the end the government opted for devaluation but was quickly forced to float the peso under panic conditions.
The ensuing crisis continues to affect the Mexican economy. Nevertheless, a relatively sound budget position, more effective economic policies, and the assistance arranged by the United States and the IMF should continue to enable Mexico to recover more quickly from this crisis than from the 1982 crash.