The Impact of the Peso Devaluation on Bankers' Access to Mexico under NAFTA by Peter S. Rose

During most of the 1980s and the early 1990s, the Mexican government set target ranges for the international value of the peso and entered the currency markets whenever the peso's exchange value fell out of a predetermined range. On December 20, 1994, Mex ico reversed course and moved away from its target range for the peso, which led to a virtual free-fall in the peso's international value of close to 40 percent between December 20 and February 1. The decision to float the peso reflected dwindling foreign exchange reserves, which had been drawn on repeatedly to fend off downward pressure on the Mexican currency.   Economic Effects of the Peso Devaluation The impact of the peso's decline on the Mexican and U.S. economies has been well publicized: The influx of cheaper Mexican imports has resulted in the slowing of some U.S. business production and sales. U.S. exports to Mexico have generally declined. Interest rates in Mexico have risen sharply. Business activity in Mexico has slowed. Unemployment in Mexico has increased dramatically, particularly among those industries relying on dollar-denominated raw materials and debt capital. Effects of the Peso Devaluation on Mexico's Banks Perhaps no sector of the Mexican economy has felt the impact of recent fluctuations in the peso's buying power more acutely than banks. The fall of the peso and skyrocketing interest rates have resulted in a surge in defaults on domestic loans and have s harply squeezed the earnings of Mexico's recently privatized banks. Bank profits have fallen because most domestic loans are tied to sensitive money market interest rates. Many Mexican borrowers can no longer service their loans because of soaring inter est rates, thereby squeezing the margin between bank loan revenues and bank borrowing costs. Loan losses have begun to erode bank capital, creating pressure on Mexico to allow greater foreign ownership of its banks in order to supply badly needed capital . Some foreign lenders have called in their credit lines extended to Mexican banks, and international rating agencies have lowered some banks' credit ratings. Many Mexican banks have drastically slowed the growth in the dollar volume of their loans out of fear of creating an even bigger loan-loss problem. Economic growth has slowed significantly because of less-available domestic credit. In this trouble-plagued economic environment, more foreign capital will almost certainly be needed to prevent additi onal bank failures.   NAFTA Then and Now The Mexican government took several steps in the wake of the peso's drastic decline. Original NAFTA treaty terms were altered to allow foreign banks and other financial service firms greater ease of entry into Mexico's home markets. The peso crisis of 1994-1995 has put tremendous strains on the balance sheets of Mexican banks. Government officials became acutely aware of the need to recapitalize their banking system with the aid of foreign investors. In February 1995, Mexico's legislative branch (with the sanction of the Ministry of Finance) approved substantially more liberal entry rules. Joint ventures between U.S., Mexican, and Canadian financial-service firms have now become more likely because Canadian and U.S. companies may acquire as little as 51 percent of a Mexican bank instead of having to control all outstanding shares of stock. Of course, there is no guarantee that foreign banks will enter quickly or in large numbers. For one thing, capitalization requirements are high-an initial commitment of reserves and paid-up capital of about $20 million to $60 million in most cases. Moreov er, recent research has shown that bankers look at multiple factors in deciding whether to enter new markets, as table 4 indicates. In autumn of 1994, forty-seven foreign-owned financial service subsidiaries were approved for entry into Mexico. Acquisition of Mexican banks (especially the smaller and more vulnerable regional banks) appears to be attractive because, until the peso's most recent devaluation, Mexican banks as a group were more profitable than most American and European banking firms. In addition, Mexico's banking system is highly concentrated, with the top three banks controlling ab out 60 percents of industry assets, which suggests less domestic competitive pressure than in many U.S. and Canadian markets. Moreover, Mexico's banks display relatively high operating costs per dollar of assets held, are less marketing-oriented than the largest U.S. and Canadian institutions, and have a population-to-branch-office ratio about four times higher than in the United States.   Benefits to the Banking Industry of NAFTA Reforms A number of benefits should follow in the wake of these major reforms of the original NAFTA agreement. Benefits for Mexico include: Increased competitiveness and efficiency of Mexican companies and greater stability in domestic employment Greater domestic savings flowing from increased public confidence in the stability of the financial system More rapid economic growth and development caused by lower interest rates on loans to businesses and consumers and greater availability of scarce capital A sizable influx of new capital, encouraging more domestic savings and, eventually, generating lower interest rates New financial expertise, resulting in a wider array of services for Mexican customers Benefits for NAFTA as a whole include: Substantial inflows of foreign capital seeking expanded business opportunities and new markets created by lower entry barriers and less regulation in Mexico Greater stability in the exchange value of the peso, attracting more imports of goods and services and more investment capital to raise living standards inside Mexico as well as inside NAFTA as a whole More opportunities for U.S. and Canadian financial-service companies, via the joint venture route, which will provide these foreign companies access to an established customer base and help these foreign companies overcome cultural and language barrie rs The result should be a win-win situation for Mexican consumers and foreign investors in the long run, after the structural problems that led to the 1994-1995 peso crisis are resolved. Dr. Peter S. Rose holds the Jeanne and John Blocker Chair of business and Administration at Texas A&M University.