Economics Update (July-December 1996)

Mexico's Liquidity-Driven Financial Panic

Conventional explanations blame Mexico's 1994 financial crisis on an overvalued peso and large trade deficit. In this second article on the Mexican crisis, however, Marco Espinosa, senior economist at the Federal Reserve Bank of Atlanta, and Steven Russell, assistant professor of economics at Indiana University-Purdue University at Indianapolis, argue that the evidence suggests an alternative explanation.

ast year the Wall Street Journal posed the question, "How could so many smart people on Wall Street, in Mexico City, and in Washington have been so blind to so many warnings?" This query encapsulates the "conventional" wisdom regarding the late 1994 crisis, which is that it was the inevitable result of fundamental imbalances in the Mexican economy. However, certain evidence suggests a financial panic (reminiscent of 19th-century financial panics in the United States) explanation.

Short-term financed growth set the stage for financial panic

In the late 1980s and early 1990s, Mexico pursued a development strategy of externally financed growth, capturing some $91 billion in net capital inflows between 1990-93. Between 1988 and 1992, this externally based financing strategy allowed the share of Mexican gross domestic product (GDP) devoted to domestic investment to rise from 20 percent to 23 percent, despite a fall in private savings from roughly 18 percent of GDP to below 9 percent.

However, much of this foreign capital inflow was short-term. For example, in 1993, the peak of the foreign-investment wave, only 32 percent of foreign funds went into the stock market, and only 13 percent took the form of direct foreign investment. Most of the rest went into short-term debt issued by Mexican commercial banks and the government. In 1993 Mexican borrowers made only 33 long-term bond issues (grossing $3.8 billion) on international markets. Only six of these involved private borrowers.

The financial panic explanation suggests that Mexico's exchange rate policies have been overemphasized and that a more important cause was the short-term nature of Mexican borrowers' liabilities. In particular, this alternative explanation does not necessarily imply that the Mexican peso was dramatically overvalued and does not interpret Mexico's large trade deficits as necessar-ily indicating that the country was borrowing or consuming at unsustainable rates.

Implications of the financial panic explanation

According to the conventional view, the economic crisis occurred because the exchange rate pegging regime allowed the Mexican peso to become substantially overvalued. This overvaluation produced a situation in which Mexicans were consuming more than their incomes at international prices.

This overconsumption was financed by foreign borrowing and was reflected in Mexico's large trade deficit. The disequilibrium ended in December 1994 when the government was no longer able to defend its exchange rate peg because it had exhausted its foreign exchange reserves. Presumably, the Mexican government could prevent future problems of this sort by permanently abandoning its policy of exchange rate pegging and allowing the peso to continue to float. The exchange rate would then adjust to keep Mexico's domestic consumption in line with its domestic income.

But under the alternative financial panic explanation, the Mexican financial crisis was clearly an expectations-driven liquidity crisis. The

The financial panic explanation suggests that Mexico's exchange rate policies have been overemphasized
immediate cause of the crisis was political turmoil that created concern among foreigners about the safety of their investments. As most of the deposits were short-term, millions of dollars were drawn off every day, producing a rapid deterioration in the government's reserve position and putting severe downward pressure on the dollar price of the peso. Ironically, in the weeks and months following the crisis it became clear that the various threats to Mexican political stability were considerably less serious than they had appeared in November and December of 1994. However, the vulnerability of the Mexican financial system to liquidity crises has been convincingly demonstrated, and foreign investors consequently remain hesitant to recommit their funds.

Vulnerable portfolios

Why did Mexican financial institutions allow themselves to acquire liability portfolios that made them so vulnerable to confidence shocks? An underlying reason is that the relatively low rate of domestic savings forced the Mexican financial system to look to foreign countries for funds to finance domestic investment. Moreover, both direct Mexican borrowers and the country's financial intermediaries were content to rely on short-term foreign credit.

Foreign short-term lenders had little reason to be concerned about long-term prospects, as it seemed certain that Mexican borrowers could continue to roll over their short-term debts using short-term funds provided by additional foreign lenders. As long as this was the case, the debts were perceived to have little default and the lenders were willing to purchase them at relatively low interest rates.

Long-term lenders, by contrast, would have recognized that the ability of borrowers to repay their loans was dependent on the long-term success of investment projects—a substantial risk—and would have demanded higher interest rates to compensate. The combination of higher interest rates and greater lender risk-consciousness would have forced Mexican firms to scale back investments, reducing both the firms' potential profits and the overall growth rate of the Mexican economy. Neither these firms nor the Mexican government was willing to accept such a slowdown in the pace of development.

Presumably, the desire to avoid these interest costs was the reason the Mexican government began pegging the exchange rate in the first place. Of course, the exchange rate pegging scheme introduced potential instabilities: any threat that the policy might have to be abandoned, whether real or imagined, could produce a self-perpetuating outflow of funds and a financial/economic disaster.

Remedies for Mexico

What, if anything, could the Mexican government have done to avoid the problem of overreliance on short-term liabilities issued to foreign investors? What can it do to prevent similar crises in the future? One might argue that the problem will eventually solve itself as borrowers become more aware of the potential risks of heavy reliance on short-term credit. However, there are reasons to doubt that changes in private behavior stimulated by this crisis will be sufficient, in themselves, to prevent future crises.

One suggestion we offer is that the Mexican government impose reserve requirements on the short-term liabilities of banks and other financial intermediaries and also on any direct short-term liabilities of Mexican firms. The reserve assets would be medium-term bonds (bonds with terms of five to ten years) issued by the Mexican government.

The purpose of these graduated reserve requirements would be to discourage Mexican banks from issuing short-term liabilities, without forbidding them to do so. The lower reserve ratios on longer-term liabilities would give them a substantial interest-cost advantage relative to short-term liabilities—an advantage that would allow Mexican financial institutions to issue longer-term liabilities at rates that would increase their relative attractiveness to domestic and foreign investors.

Allowing the peso to float might have made a financial crisis less likely. Therefore, Mexico should stick with its current flexible exchange rate regime—as it appears to have every intention of doing. However, exchange rate risk is certain to remain troubling to foreign investors and will provide a source of financial instability.

One approach to reducing the severity of the exchange rate risk problem would be for the Mexican government to encourage the country's banks and other borrowers to issue dollar-denominated debts. A second step might be to require that at least a minimum fraction of the foreign liabilities of Mexican financial intermediaries be dollar- or other-foreign-currency-denominated.

Clearly, one factor that contributed greatly to the financial crisis was Mexico's strategy of externally financed development. Unfortunately, it is unrealistic to expect Mexicans to increase their savings to the extent necessary to allow Mexico to resume its precrisis development path without relying on foreign funds. It is equally unlikely that the government will be willing to accept the much slower growth rate attainable through reliance on the current level of domestic savings.

Perhaps the most important step toward alleviating the credit squeeze would be continued progress toward deregulating the financial industry and exposing it to more vigorous domestic and foreign competition as well as drafting measures that help lengthen the country's borrowing term structure. Hopefully, deregulation would stimulate domestic investment enough to reduce the strong demand for foreign finance.

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