TEQUILA SENOR : THE MEXICAN PESO CRISIS Essay

This essay has a total of 1626 words and 8 pages.

TEQUILA SENOR : THE MEXICAN PESO CRISIS

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 cetes 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 tesobonos were
issued aggressively instead of peso-denominated cetes. This was likely due to investors
being more willing to hold tesobonos as they will be covered against the risks of
devaluation and also lower interest rate for tesobonos than cetes. 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 Donaldo Colosio on 23 March and the Secretary of PRI, Partido Revolucionario
Institucional, Jose Francisco Puiz 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 unrests. The investors were already very uptight. Just one
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