The sharp depreciation of the Mexican peso in December 1994 marked one of the swiftest macroeconomic reversals in the history of developing economies and currency crises. President Ernesto Zedillo had barely been in office three weeks when, on December 19, 1994, his administration asked the Banco de Mexico to undertake roughly 15 percent devaluation of the peso, adjusting the pegged exchange rate from 3.45 pesos per dollar to 4.00 pesos per dollar (Sharma, 2001). It was a modest devaluation, but it undercut the confidence of foreign investors and touched off a wild speculative run against the peso. On December 22, 1994, the Banco of Mexico, unable to defend the peso against stampeding, panic-stricken foreign investors, allowed the peso to float. The peso immediately sank another 15 percent (Sharma, 2001). By February 16, 1995, the peso had depreciated 42 percent against the U.S. dollar (Torres, February 1995). The peso reached its nadir at 7.65 pesos per U.S. dollar (Sharma, 2001).
The outgoing President Carlos Salinas and the soon-to-be President Zedillo met on November 20, 1994, to discuss the currency situation. The Friday before, Mexico had lost $1.7 billion in a run on the peso. The two leaders agreed that devaluation on the order of 10 percent was needed, but the outgoing officials refused to devalue the currency on their watch (Wessel, July 1995).
The peso crisis caught many observers and investors by surprise. Mexico had become the darling of Wall Street. Mexico’s economic policy seemed to have all the right ingredients. It emphasized privatization and deregulation of state-owned enterprises, restrictive monetary and fiscal policies, and a pegged exchange rate relative to the U.S. dollar. The ratification of the North American Free Trade Agreement (NAFTA) in January 1994 opened Mexico’s economy to the largest consumer market in the world. Between 1989 and 1994, Mexico’s gross domestic product (GDP) growth averaged 3.9 percent (Sharma, 2001). Mexico’s inflation rate, which raged as high as 160 percent in 1987, sank to single-digit territory in 1993 (Sharma, 2001). Government indebtedness as a percent of GDP shrank from 15 percent in 1987 to 1 percent in 1992 and 1993 (Sharma, 2001). Between 1987 and 1994, government spending as a percent of GDP shriveled from 44 percent to 24.6 per cent (Sharma, 2001). In February 1994, Mexico’s foreign exchange reserves stood at $28 billion, well above the $6.3 billion level held in 1989 (Sharma, 2001). With the dawn of NAFTA, Wall Street saw no limits to Mexico’s potential.
In hindsight, one economic statistic signaled trouble. Mexico’s current account deficit steadily climbed from $6 billion in 1989 to $20 billion by the end of 1993 (Sharma, 2001). Mexico’s imports were growing much faster than its exports. Current account deficits reflect either a high level of government deficit spending, high levels of private investment spending relative to savings, or some combination. In 1994, government deficit spending in Mexico was minimal, and the high level of private investment spending seemed to reflect Mexico’s bright future under NAFTA. Foreign portfolio investments in Mexican stocks and short-term bonds made possible the high level of investment spending. It also left Mexico vulnerable to a sudden outflow of foreign capital.
In 1994, foreign investors began to get jittery over the size of Mexico’s current account deficit. Mexico tamed inflation, but did not eradicate it. Under a pegged exchange rate, inflation increases the prices of domestic goods, but does not affect the price of imported foreign goods unless the peg is adjusted. Mexico failed to adjust the pegged exchange rate to compensate for domestic inflation, encouraging Mexico’s consumers to purchase more imported goods at the expense of domestically produced goods. As long as foreigners exhibited a strong appetite for Mexican stocks and bonds, the Mexican government felt no pressure to devalue its currency. The peso appeared to be in high demand at the current exchange rate.
In 1994, the strong foreign demand for portfolio investments in Mexico began to diminish over worries about Mexico’s rising current account deficit. Rising current account deficits often lead to a devaluation of a currency. If a currency depreciates 25 percent, foreign investors immediately see the value of their investment depreciate by 25 percent.
Part of the attraction of Mexican stocks and bonds had to do with low interest rates in the United States. Throughout 1993, the U.S. federal funds rate remained at 3 percent. In 1994, the Federal Reserve System started raising the federal funds rate, pushing it up to 5.5 percent by November 1994 (Sharma, 2001). As interest rates rose in the United States, investors became less willing to chase higher interest rates in developing countries and emerging markets. When the Mexican government announced a devaluation of the peso in December 1994, foreign investors decided it was time to get out of Mexico.
After the peso crisis, Mexico’s economy sank into steep recession. Inflation soared as devaluation lifted the prices of imported goods. In the United States, President Bill Clinton put together a nearly $50 billion rescue package (Greenwald and Carney, 1995). Without the rescue package, the Mexican government would have defaulted on a large amount of dollar-denominated government bonds. (In 1994, the Mexican government had started issuing dollar-denomniated bonds to ease investor fears about devaluation of the peso.) The rescue package helped calm markets and limited the damage inflicted on other Latin American countries.
See also: East Asian Financial Crisis, Currency Crises
