The Peso Devaluation in Retrospect by Jared E. Hazelton

What a difference a year makes! At the end of last summer, Mexico was riding high with NAFTA in hand, several years of economic reform under its belt, a balanced budget, a respectable level of external debt, and a new president elected in a widely acclai med open and fair election. Since then, however, the value of the peso has plunged 40 percent, casting a dark spell over NAFTA and recent reforms. Mexico's economy is in shambles and the new president is facing rising political unrest. How did the Mex ican "miracle" turn into an economic and political morass in such a brief period? What are the prospects for Mexico's recovery? What lesson can be learned from the peso's most recent plunge?   What Went Wrong Devaluation of the Mexican peso resulted from familiar causes: a sizeable and growing current account deficit (i.e., an excess of imports over exports), over-expansion of the money supply, and over-reliance on short-term borrowing. Mexico's leaders believed that the country's persistent current account deficits were simply the normal counterpart to huge capital inflows representing foreign investment in what seemed to be an exceedingly promising market. From 1990 through 1994, howe ver, direct investment in plant and equipment accounted for less than a quarter of the total inflows. The rest came from portfolio investment in equities and bonds, largely by mutual funds. Unlike direct investment, portfolio investment can depart for perceived greener pastures with the speed of light. As long as the capital inflow continued, however, Mexico was able to maintain the value of the peso and accumulate foreign exchange reserves of more than $25 billion at the end of 1993. In 1994, however, the situation changed. The PRI presidential candi date, Donaldo Colossio, was assassinated. The Zapatista uprising in the southern province of Chiapas heightened political tensions, and another assassination, of reform-minded PRI-leader Jose Francisco Ruiz Massieu, as well as kidnappings of prominent ex ecutives added to the political turmoil. The resulting uncertainty led many investors to take their money elsewhere. Meanwhile, in the United States, the Federal Reserve began raising short-term interest rates to combat inflation, providing added reward to capital fleeing Mexico. The Mexican central bank facilitated the conversion of pesos into dollars by purchasing foreign-owned financial assets directly and by extending credit to the banking system. Had the central bank refused to take these actions, the sales of such assets wo uld have caused their prices to decline and interest rates to rise, slowing the outflow of capital. However, facing what was initially viewed as a close election, the Salinas administration opted for easy money and the central bank meekly complied. When the inflow of capital fell short of plugging the gap between imports and exports, Mexico resorted to issuing short-term domestic debt. (The country's 1982 foreign debt crisis denied it access to the international market for long-term capital.) To a ttract investors, the Mexican Treasury issued dollar-denominated instruments called tesobonos. As foreign capital continued to flow out and the import surplus continued to rise, Mexico's dollar reserves dwindled, and it was forced to enter the short-term money market more frequently. In the end, given its rising current account deficit and the political uncertainty which was keeping foreign investors away, there was simply no way Mexico could maintain both low interest rates and an over-valued peso. Only after its foreign exchange re serves were nearly depleted, however, did newly installed President Ernesto Zedillo opt for devaluation. On December 20, the government announced that the restrictive band within which the peso was permitted to trade would be raised 15 percent. Unfortun ately, the announcement caught investors by surprise and the government without a plan for restoring fiscal discipline. As a result, with confidence collapsing, a speculative run against the peso ensued on the following day, and the nation's foreign exch ange reserves plunged by about $6 billion in a few hours. Only then was the decision made to let the peso float, i.e., let market forces set its prices.   Recovery Plan On January 31, President Clinton announced a $51 billion assistance plan for Mexico that did not require Congressional approval. The bail-out funds, only $20 billion of which come directly from the United States, are intended to help Mexico weather the immediate crisis by restructuring its debt to lengthen the average maturity as well to provide assistance to troubled banks. Mexico's basic economic problem, however, is its need to reduce its dependence on short-term flows of money by slashing its curr ent account deficit. Devaluation helps, of course, because imports become more expensive and exports become cheaper. But devaluation gains can be lost if prices and wages are permitted to rise. As a condition for assistance, Mexico is required to rein in its central bank and its over-expansive monetary policy as well as to take other actions to hold the line against inflationary pressures. The austerity program, finally announced on March 9, contained bitter medicine for the Mexican people: raising the value added tax from 10 percent to 15 percent; increasing the price of gasoline by 35 percent, with additional 0.8 percent per month hikes throughout the rest of the year; increasing the price of electricity by 20 percent; and, cutting government spending 10 percent by scrapping planned infrastructure projects, laying off government workers, and reorganizing departments. These measures are expected to virtually eliminate most of the current account deficit and stabilize the peso's value. But this progress comes at a high cost. The government estimates that in 1995 Mexico's output of goods and services will drop by 2 per cent, 750,000 workers will lose their jobs, and inflation will still average 42 percent for the year. Private sector forecasts are even more pessimistic. At first glance, the austerity plan appears to be working. In the first quarter, Mexico's trade balance reversed, and the country ran a slight surplus. Of the $29 billion in tesobonosmaturing in 1995, $16 billion have been retired. The peso appe ars to have stabilized at about six to the dollar. While interest rates remain high, they are falling and values on the bolsa have risen more than 30 percent from their March lows. For the average Mexican, however, the economy remains in crisis. In th e first four months of 1995, prices rose nearly 24 percent. The interest rate on short-term government borrowing remains over 60 percent. The shaky banking system is being battered by problem loans, which are estimated to total 10% of the nearly $70 bil lion outstanding. Economic activity is at a standstill. Because one in two Mexicans is under 20 years of age, the country needs to create a million jobs a year just to stay even. Instead, over a half a million Mexican workers have already lost their j ob this year, and at least a quarter of a million more jobs are likely to disappear in the coming months.   The Real Test May Be Political The austerity plan is bitter medicine for a nation where per capita real incomes are perhaps as much as 10 percent below their 1980 level. While President Zedillo persuaded the major trade unions to agree to the austerity plan (albeit, after-the-fact), t he powerful business chamber, the Mexican Manufacturers Confederation, adamantly rejected it. Ordinary workers and proprietors of small and mid-size businesses view the plan as an unmitigated disaster. The major opposition party, the PAN, is taking adva ntage of the situation to make political gains in state and local elections. President Zedillo is being forced to play two demanding roles. As a tough fiscal administrator, he must persuade Mexicans to tighten their belts once again to prevent the gains from devaluation from being wiped out by spiraling wages and prices. At the same time, as a political reformer, he must convince the different elements within his own party, the PRI, to willingly give up some of their traditional power. Leadership in the PRI is obviously concerned about the electoral fall-out from asking Mexican s to tighten their belts, now that they have the political freedom to express their discontent at the ballot box. Unfortunately, the more successful Zedillo is in reforming the party, the less power he has to implement his austerity plan.   A Painful Lesson While the December devaluation debacle was the fourth peso crisis in the past two decades, it was nonetheless unique because it was the first major currency disruption to occur in the new competitive globalized financial system. In the past, developing countries relied on loans from foreign banks and public institutions to augment domestic investment funds. Countries got into trouble when they couldn't service that debt. The focus was on the domestic budget and the extent of external borrowing. Today, development capital is more likely to come from private nonbank sources: mutual funds, other institutional investors such as pension funds and life insurance companies, securities traders, and even nonresident individuals. Private capital flows to developing countries have tripled since 1990, and about half are in the form of portfolio (stocks and bonds) investment. In this new financial environment, even if a country has a balanced budget and a low level of external debt, it may nonetheless g et into currency difficulties if it loses the confidence of foreign investors. Because expectations play a large role in determining the direction and magnitude of portfolio capital flows flow in both directions - in and out, they represent a fickle and risky base of support for long-term investment. The most recent peso crisis demonstrates that the source of capital inflows to a developing country may be as important as their magnitude. In one sense, Mexico was victimized by its own success in reforming its economy and opening its markets. These a ctions enabled it to attract an inflow of volatile portfolio capital to finance long-term development needs. But they also made Mexico more vulnerable to disruption when investor expectations changed. It now faces the long, difficult, and painful task o f restoring confidence before it can begin to move forward once again. Dr. Jared E. Hazleton is Professor of Finance and Director of the Center for Business and Economic Analysis at Texas A&M University.