Essays24.com - Term Papers and Free Essays
Search

Tequila Senor : The Mexican Peso Crisis

Essay by   •  October 31, 2010  •  1,605 Words (7 Pages)  •  2,000 Views

Essay Preview: Tequila Senor : The Mexican Peso Crisis

Report this essay
Page 1 of 7

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 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

...

...

Download as:   txt (9.8 Kb)   pdf (120.7 Kb)   docx (12.8 Kb)  
Continue for 6 more pages »
Only available on Essays24.com
Citation Generator

(2010, 10). Tequila Senor : The Mexican Peso Crisis. Essays24.com. Retrieved 10, 2010, from https://www.essays24.com/essay/Tequila-Senor-The-Mexican-Peso-Crisis/6128.html

"Tequila Senor : The Mexican Peso Crisis" Essays24.com. 10 2010. 2010. 10 2010 <https://www.essays24.com/essay/Tequila-Senor-The-Mexican-Peso-Crisis/6128.html>.

"Tequila Senor : The Mexican Peso Crisis." Essays24.com. Essays24.com, 10 2010. Web. 10 2010. <https://www.essays24.com/essay/Tequila-Senor-The-Mexican-Peso-Crisis/6128.html>.

"Tequila Senor : The Mexican Peso Crisis." Essays24.com. 10, 2010. Accessed 10, 2010. https://www.essays24.com/essay/Tequila-Senor-The-Mexican-Peso-Crisis/6128.html.