Mexicos Balance of Payment Problem - Mexicos Tequila Crisis 1994 - Case Study Example

1.0 Abstract.

The Mexico balance of payments difficulties were escalated by the peso crisis of 1994. This paper focuses on the trend of the balance payments difficulties in Mexico between the year 1994 to 19996 as well as the causes of this financial crisis. One of the results of this crisis was the trade deficit in Mexico. This increasing trade deficit happened at the same time with economic increase of foreign investment in early 1990’s. A lot of foreign capital inflow in Mexico increased down from 3.5 billion U.S. dollars in the year 1989 up to 33.3 billion U.S. dollars in the year 1993, enabling the nation to make up of the increased trade imbalances and operate current account deficits, which was unprecedented on time. The flow of foreign investments to Mexico, also further worsened the peso valuation by overvaluation, creating even more demand for imports and hence escalating the trade deficit. This caused a major destabilization force that contributed to the payment imbalance crisis by its impact on the balance of Mexico’s current account. Normally, payment balance identity provides that the deficits of current accounts should be funded by flows of individual capital or a decline of reserves of foreign exchange. During the time that preceded this crisis, flows of individual capital in Mexico was more compared to the required to pay for the deficit of current account. In the year 1992 and also 1993 deficit of the current account in Mexico was 48 U.S. dollars compared to the capital (private) flows which were 57 U. S. dollars (Edwards, 1998).

1.0.1 Introduction.

Mexico experienced deficits of trade in large-scale, foreign reserve holdings depletion and a great devaluation of her currency in December the year 1994. This was subsequently followed by a decision to float peso freely. The occurrence of the events resulted in the serious recession, poverty together with high unemployment in the state. During this time of the year, there was a financial crisis that was otherwise termed as “Tequila Crisis” that began after the Mexico peso devaluation in December 1994. This caused a great crisis in banking in Mexico, vast currency depreciation in one single year of around 5.3 (pesos) for one dollar to about 10 (pesos) or more for one dollar from 1994 December and 1995 in the month of November. Though Mexico had experienced a lot of consecutive deficits of trade all way to 1994 December but, the currency was not for political reasons allowed to depreciate. The government in Mexico was against loss of value of its peso before the election of the president in the year 1994. Peso currency if it was slowly allowed to depreciate in comparison to other currencies, it would not have caused the serious peso crises (Edwards, 1998). The paper is organized with section 2 providing the trend of Mexico economic indicators, section 3 providing for Causes of Mexico’s balance of payments difficulties, section 4 providing for Mexico’s imports and exports industries, section 5 providing for Lessons to the developing countries and section 6 providing the conclusion.

2.0 Trend in Mexico economic indicators during 1994 – 1996.

In early 1990’s Mexico was noticed as deserving economic reforms. This is because it had stagnated economically and was about to become a member of the NAFTA and OECD. Peso crisis of 1994 revealed that Mexico suffered from unsustainable financial policies. In an examination of this crisis the model of balance of payments crisis will be used, which shows the way change in the exchange rate results to a change in foreign reserves. The central bank used reserves to finance private capital flow so that to keep the exchange rates fixed (Edwards, 1998).

Mexico’s trade liberalization together with the peso’s appreciation caused an increase in the country’s imports compared to its exports. This increasing trade deficit happened at the same time with economic increase of foreign investment in early 1990’s. A lot of foreign capital inflow in Mexico increased down from 3.5 billion U.S. dollars in the year 1989 up to 33.3 billion U.S. dollars in the year 1993, enabling the nation to make up of the increased trade imbalances and operate current account deficits which is unprecedented on time. The flow of foreign investments to Mexico, also further worsened the peso valuation by overvaluation, creating even more demand for imports and hence escalating the trade deficit. This now caused a major destabilization force that contributed to the payment imbalance crisis by its impact on the balance of Mexico’s current account. Normally payment balance identity provides that the deficits of current account should be funded by flows of individual capital or a decline of reserves of foreign exchange. During the time that preceded this crisis, flows of individual capital in Mexico was more compared to the required to pay for the deficit of current account. In the year 1992 and also 1993 deficit of the current account in Mexico was 48 U.S. dollars compared to the capital (private) flows which were 57 U. S. dollars (Edwards, 1998).

Mexico reliance on foreign investments to finance her deficit of current account was indulging in a risky deal. From the year 1990, foreign investment in the upcoming markets had greatly taken investment portfolio form. Portfolio investment in Mexico that did not exist in 1989 had risen to 28.4 US dollars in 1993. This was caused by the increased capital flows of 33.3 billion in that year. Portfolio investments are very volatile generally compared to traditional direct foreign investments and very susceptible to flight in the encounter of a risk. Those in charge of making policies in Mexico, though in recognition of dangers caused by the increasing deficit in the current account, overvalued currency, as well as portfolio flow dependence, allowed unnecessary optimism in them compromise the decisions they made. The Mexican policy makers at that time believed that the state’s economic status would continue to be impressive to investors from foreign nations for longer in which it would support flows of capital from foreign nations dependence, as the exports and imports gap was slowly diminishing. It is this belief which was founded on the high economy competitiveness in Mexico together with the proper implementation of NATFA successfully (Eun and Resnic 2000).

1993 and early 1994, despite the knowledge of unsustainable Mexico current account deficit and the overvalued currency, investors continued to run foreign exchange into the Mexico’s economy. Later in 1994 was a series of political events that adversely affected the confidence of foreign investors in Mexico. Starting with the Chiapas uprising which was in the beginning of the year and in March resulting to the assassination of the PRI’s presidential candidate and this saw Mexico increase its risk. Unfortunately, these political events occurred at the same time with the Federal Reserve in U.S decision of interest rates increment in February that year. This increase in the interest rates in U.S changed the flow of investments away from the emerging markets in general which increased the premium risk of Mexico. Mexico after this experienced a serious drop in international investments hence a decline in its foreign capital flows. Due to this, Mexico was forced to pay for its deficit in the current account via the foreign reserves in their state of depletion. In turn, foreign reserves of Mexico fell by the end of March to 18 billion US dollars from 26 billion US dollars (Eun and Resnic, 2000).

Towards the end of the year 1994, a government in Mexico tried to counter the increasing interest rates and contraction of money, by extending the domestic credit. Buying of securities privately owned by central bank at low interests in comparison to those of investors, was how all this was achieved. This credit since it was a government’s short-term debt was then converted into dollars in an attempt to prove that the peso was still strong. This debt was given in small bills and also was better impressive for investment than peso debts. With the Mexican government converting its debt to dollars it shifted the risk to itself from the investors. However the international markets did not see this effort as credible and now the outstanding debt for the country made it prone to various financial problems. The expansion of the financial policies by the government only fueled the depletion of their foreign currency reserves since the caused the domestic interest rates to fall while those of the US continued to rise. Investors saw that the Mexico’s financial position had become unstable and bean to prepare themselves for devaluation (Eun and Resnic 2000).

Mexico’s foreign reserves had fallen to around 10 billion US dollars by December 1994, which was inadequate to pay outstanding 30 billion US dollars held by investors in debt. “Pact” and the government held a meeting where it was agreed that a devaluation of 15 percent should be allowed. After the devaluation on 20th December about 5 billion US dollars was taken outside the nation. It now became evident that new rates of exchange were improper and the government subsequently chose to float its peso. Investors who held debts inform of peso currency, claimed to have been betrayed by the Mexican decision and many observers were astonished saying that the float was declared without the rational macroeconomic plan to contain the consequences. In few weeks, the investors freed from Mexico causing serious adverse impact (Eun and Resnic 2000).

The Mexican government devised and declared a plan to solve the inflationary and negative impact of the crises in January 1995. This plan recommended the reduction of the government spending and contracting the monetary policies, particularly the amount of credit that will be availed to domestic borrowers. Establishment of a floating exchange rate system that is coherent was another recommendation in the plan. This step was taken to ensure the accurate value of the peso in the market for long and avoid reoccurrence of overvaluation of the currency as well as broaden the export competitiveness. The government also resorted to soliciting assistance from foreign entities, particularly the commercial bank of US in the admission of their inability to succeed in fixing the crisis. By 2005, the country had managed to obtain various loans and other credit which summed up to about 52 billion U.S. dollars. This encompassed the biggest in history the IMF loan of 17.8 billion US dollars (Eun and Resnic 2000).

3.0 Causes of Mexico’s balance of payments difficulties

Current account deficit and exchange rate overvaluation were the key problems that affected the Mexican economy in 1994. However several other factors like the elections that caused the poor environment for foreign investors giving them a lot of fear of investing in Mexico, the increase in the US interest rates compared to Mexico peso value and loose monetary policy to control inflation also were other problems (Salop at el, 1980).

3.0.1 Current account deficit

In the year 1988 and 1994 Mexico suffered an increased current account deficit reaching up to 30 billion US dollars. This made Mexico become too vulnerable to macroeconomic instability. Export growth in Mexico between 1989 and 1993 was around 8.7 percent of exports per year while the current account deficit was on an average of about 31.7 percent of exports. This indicated the great state’s foreign liability, which in turn impacted negatively on the balance of payments (Salop at el, 1980).

3.0.2 Exchange rate overvaluation

The nominal exchange rate was the major element of the macroeconomic stabilization program in Mexico. Since May the year 1988, the exchange rate was fixed to the dollar as a measure to control inflation. By 1989, the exchange rate policy had begun to gradually increase while the nominal exchange remained in constant prices. Beginning the year 1991, to the end of the year 1993 nominal exchange rate, fell by 5.4 percent. The exchange rate became difficult to stabilize since inflation had greater force despite the presence of price and wage controls. In early 1991 to the end of 1993 wholesale prices in Mexico rose to about 30 percent compared to the US wholesale prices negatively affecting the Mexican economy(Eun and Resnic 2000).

4.0 Mexico’s imports and exports industries

Companies in Mexico whose sales depended on both exportation and national markets stressed the importance of exports after the devaluation happened. Companies with both markets began to export more compared to selling in Mexico. The major reason was because the new exchange rates after devaluation increased the profits on peso based sales. Therefore, they preferred to export their products and in return receive dollars in place of pesos that now were evaluated. For instance, some steel companies based in Mexico reported in January 1995 an increase in profit by about 50 percent. It is after devaluation that some import and export firms expanded. The reason for this growth was as a result of taking advantage of the cheap assets and availability of many companies that were looking for supplies that were less expensive. For example, the American Monroe, which makes shock absorbers and struts and Takata from Japan expanded after the devaluation (Salop at el, 1980).

Companies that had been exporting goods already prospered forthwith for the reason that there was profit increase after the peso devaluation with over a hundred percent from 1995. These companies are very competitive in the world and their products have a good value in the markets internationally. These companies compared to many industries took the best advantage over the economic crisis. What they did is that they paid inputs together with labor in peso currency, but they made their sales in dollars. Further to the advantage of price, the domestic demand was lowered by the devaluation and encouraged manufacturers to consider export markets. NAFTA also benefited some companies after this crisis, by for example enabling the companies that use heavy trucks with the Free Trade to bring new trucks into Mexico with a low pay of 8 percent tax. The other response to the decrease in demand after the crisis of the Mexican exporting business was the shifting of many industries in Mexico to United State (Salop at el, 1980).

5.0 Lessons for developing countries

The main lessons that can be learned from the peso crises by the developing nations are first; lack of reliable economic information that openly states the economic status of a country can result in a financial crisis. Lack of such information was a great influencing factor of the crisis of peso. Salinas’s governance failed to frankly reveal the true state of the economy in Mexico which lead to the collapse of the peso. If investors were aware, that Mexico experienced serious trade deficits, and foreign exchange reserves rapid depletion, the peso would not have gradually depreciated, but not collapse suddenly as it happened. A transparent frank disclosure of economic information helps to prevent events like the peso crisis (Salop at el, 1980).

Second is to avoid a lot of dependence on foreign capital flows. Mexico depended too much for its economic growth on a short term foreign capital inflow of which can be unreliable. Mexico, for instance, could have concentrated on a domestic saving and depend more on long-term foreign capital. When developing countries do this, they will be able to easily avoid financial crises. Third is to learn how to safeguard the financial systems of the world from the fiscal crisis like the peso crisis. This is because world financial system if not safeguarded can impact on the exchange rates which can result in inflation rates in a country. To this effect, a net of multinational safety needs to be in place (Salop at el, 1980).

5.1 Fixed or flexible exchange rates

Flexible exchange rate is the exchange where the value of a currency is determined only by the forces in the market while fixed rate of exchange contrasts the currency value to another or various other currencies and sometimes to a fixed amount of goods. Flexible rates of exchange are preferred over the fixed because they work according to market movements and other principles of demand and supply and controls imbalances in international financial systems (Salop at el, 1980).

6.0 Conclusion

Mexico balance of payments difficulties were largely contributed by improper management of the financial sector of the state. The government should have established and implemented proper financial policies that would-would protect the value of the peso in the international markets and curb inflation in the country. Fear of disclosing the true economic status of Mexico's economy to investors also escalated the situation of devaluation in Mexico. Measures like desisting from overdependence on short-term foreign capital inflow by Mexico and policies to reduce inflation rates have seen a new rise of Mexico which is a good example to learn from for other developing nations.