The Mexican Peso Crisis:

A Balance of Payments Crisis

(1994 – 1995)

International Financial Policy

April 13th, 2005

Tyler Curtis
Donn Gladish
Mayuri Guntupalli
Bill McElnea
 Mexico’s Balance of Payments Crisis (1994-1995)

Introduction
In the early 1990’s, Mexico was being heralded as a model of economic reform. Mexico
had turned the corner on decades of economic stagnation and was on its way to becoming
a member of the OECD and NAFTA. The 1994 peso crisis revealed that Mexican growth
was ultimately a façade, supported by unsustainable monetary and fiscal policies. To
examine the Mexican Peso Crisis, we use the balance of payments crisis model, which
shows how an expected change in the exchange rate leads to a change in official foreign
reserves. In order to hold the exchange rate fixed, the central bank used reserves to
finance private capital flow.

Peso/dollar
exchange Rate, SP/$ Peso return
1
Peso return2

1' Expected2
dollar return
S1P/$ 2'

Expected1
dollar return Rates of return
(in peso terms)
1
S 02 R $ R2$
M MEX
PMEX L(RP, YMEX)
Decreasing MS
MSMEX1 Mexican real
money
PMEX 1 supply

Mexican real money holdings

I. Origins of the Crisis Inflation (CPI) and Portfolio Investment 1987 - 1993
140.00 35,000.00

30,000.00
The economic crisis that followed Mexico’s 120.00

25,000.00
devaluation in December of 1994 was a shock to 100.00
20,000.00
most observers. In the early 1990s, Mexico’s 80.00
15,000.00
extensive economic reforms had largely reversed 60.00
10,000.00
the stagnation and instability that plagued the 40.00
5,000.00
country in the 1980s, and through a foreign 20.00 0.00

0.00 -5,000.00
1987 1988 1989 1990 1991 1992 1993

% Change CPI Portfolio Investment ($ millions)

exchange regime pegging the peso to the U.S. dollar, the country was able to curb its
chronic high inflation. These reforms made Mexico an attractive destination for foreign
capital, leading to an unprecedented boom in portfolio investment. While these flows
initially helped to support Mexico’s economic reforms, they would later serve to
undermine them and eventually play a central role in the country’s balance of payments
crisis.

To understand the causes of Mexico’s balance of payments crisis, it is essential to

observe the evolution of the country’s current account deficit. From the very beginning of
Mexico’s economic reform process, combating inflation was a focus of Mexico’s
policymakers. The primary component
Spot Exchange Rates January 1994 - December 1
of Mexico’s anti-inflationary policy Mexican Pesos/US Dollars *Source: UBC Sauder Schoo
9
was its exchange rate regime, which 8
was initially fixed to the dollar in 1988 7
as part of the Pact of Economic 6
Solidarity Plan (or “Pacto”), but later 5
modified to a peg, and at the time of 4
the crisis, to an adjustable band. This 3
exchange rate regime was highly 2
1
effective in curbing Mexico’s 0
inflationary pressures, but resulted in

11/5/94

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12/5/94
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12/5/95
the appreciation of the peso (nominal
exchange rate-based stabilization has
long been shown to result in the real appreciation of the local currency, typically due to
the time lag between domestic and foreign inflation decreases).

Capital Inflows of the Early ‘90’s and Current Account Effects

The peso’s appreciation, when combined with Mexico’s unilateral trade liberalization,
fed a surge in the country’s imports, which were rapidly outpacing its exports. This
growing trade deficit coincided with the foreign investment boom of the early 1990s.
Gross capital flows to Mexico surged from US$3.5 billion in 1989 to US$33.3 billion in
1993, allowing the country to cover its
Current Account ($ Millions)
growing trade imbalance and in time run
1
unprecedented current account deficits . 5000

Foreign investment flows to Mexico, 0

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003
further exacerbated the overvaluation of -5000

the peso, which in turn fueled even -10000

greater demand for imports, further -15000

worsening the trade deficit. This cycle -20000

would prove to a major destabilizing -25000

force leading to the balance of payments -30000
crisis through its effect on Mexico’s -35000
current account balance. Year

1
Banco de Mexico
Fundamentally, the balance of payments identity dictates that a current account deficit
must be financed by private capital flows or by a decline in foreign exchange reserves. In
the period immediately proceeding the crisis, Mexico’s private capital flows were more
than enough to finance the current account deficit. During 1992 and 1993, Mexico’s
current account deficit was US$48 billion, while private capital flows were US$57
billion2.

Dependence on Debt Portfolio Investment

By relying on foreign investment to finance its current account deficit, Mexico was
exposing itself to a great deal of risk. Since 1990, foreign investment in emerging
markets had increasingly taken the form of portfolio investment. In the case of Mexico,
portfolio investment that was practically non-existent in 1989 had risen to US$28.4
billion in 1993. This was out of gross capital flows of US$33.3 billion in the same year. 3
Portfolio investments are generally more volatile than traditional foreign direct
investment and more prone to flight in response to perceived risk.

Mexico’s policymakers were not unaware of the dangers presented by their overvalued
currency, growing current account deficit, and reliance on portfolio flows, but they
allowed undue optimism to cloud their judgment. The prevailing belief among Mexican
policymakers was that the country’s economy would remain attractive to foreign
investors long enough for their dependence on foreign capital flows to subside, as the gap
between imports and exports gradually closed. This belief was predicated on the
increasing competitiveness of the Mexican economy and the successful implementation
of NAFTA.

II. Decline in Investor Confidence and Devaluation

In 1993 and early 1994, investors continued to pump foreign exchange into the Mexican
economy despite evidence of Mexico’s unsustainable current account deficit and its
overvalued currency. It would turn out to be a series of political events in 1994, which
would begin the process of undermining investor confidence in Mexico. Beginning with
the Chiapas uprising at the beginning of the year and culminating with the assassination
of the PRI’s presidential candidate in March, Mexico saw its risk premium quickly rise.
These political events coincided with the decision by the United States Federal Reserve
to raise interest rates in February. The increase in U.S. interest rates altered investment
flows away from emerging markets in general, and would compound the effect of
Mexico’s increased risk premium. (BOP graph, Point 1 to 3)

2
Naim, M. "Mexico's Larger Story." Foreign Policy, No 99, p.112-130, Summer 1995
3
Lustig, Nora. “The Mexican Peso Crisis: the Foreseeable and the Surprise.” Brookings
Discussion Papers in International Economics No. 114, June 1995
After the March assassination Mexico Mexican Foreign Reserves (US$ b
*IMF International Statisitcs
experienced a dramatic drop in its foreign
35.00
capital flows. With declining international
30.00
investment, Mexico had to finance its current
25.00
account deficit through the unsustainable 20.00
depletion of its foreign reserves. By the end of 15.00

March, Mexico’s foreign reserves had fallen 10.00

from US$26 billion to US$18 billion.4 5.00

0.00

1/1994
2/1994
3/1994
4/1994
5/1994
6/1994
7/1994
8/1994
9/1994
10/1994
11/1994
12/1994
1/1995
2/1995
3/1995
4/1995
5/1995
6/1995
7/1995
8/1995
9/1995
10/1995
11/1995
12/1995
Mexico now had two options to stabilize its
growing balance of payments imbalance: (i)
they could have devalued their exchange rate Lending Interest Rates in Mexic o

and relieved the pressure on the current 100.00

account, or (ii) they could attempt to defend 90.00

their exchange rate by raising interest rates. 80.00

70.00
They chose the latter, with the expectation that 60.00
they could wait out the economic turmoil. As 50.00
40.00
is illustrated by the balance of payments crisis
30.00
model, the increased risk premium resulted in 20.00
a rightward shift of the expected domestic 10.00
0.00
currency return on foreign currency assets 4 5
94 94 94 94 94 99 95 95 95 95 95 99
curve. Given that the exchange rate remained 19 /19 /19 /19 /19 /1 19 /19 /19 /19 /19 /1
1/ 3 5 7 9 11 1/ 3 5 7 9 11

fixed (except for a movement from the lower

end of the band to the ceiling of the band which acted as a de facto 10% devaluation),
interest rates on Mexican treasury certificates, or cetes, shot up to 16.25%5.

An Expansionary Response to Capital Flight

In the last quarter of 1994, the Mexican government attempted to counter growing
interest rates and monetary contraction, with an extension of domestic credit. This was
accomplished through the purchase of Effects of expansionary monetary
private sector securities by the Central Bank policy on the AA curve
at interest rates lower than those demanded Spot exchange
rate, S
by foreign investors. This attempt to sterilize DD
the fall in international reserves would prove
to be incompatible with defense of the
exchange rate peg. 2
S
2

1
In an attempt to show the global market that S
1
the peso was still strong, the credit was
converted into dollars, as was the
AA
government’s short-term debt. This dollar- 2

AA
1

4
Ibid. Y
2
Y
1
Output, Y
5
Sachs, et. al. “The Collapse of the Mexican Peso: What Have We Learned” Economic
Policy 22 (April 1996). Pg 13-63
denominated debt was issued in bills called tesobonos, and were more attractive to
foreign investors than “high-risk” peso denominated debt. Thus, by indexing its debt to
the dollar, the Mexican government was transferring risk from investors to itself.

Despite Mexico’s efforts to defend their pegged

Mexican and US Treasury Rates
exchange rate, international markets did not find
the effort credible and the country’s now 60
outstanding (dollar-denominated) debt made it 50
susceptible to a number of financial shocks. As the 40
expectation of a future devaluation increased, so Mexican Treasury Bill
Interest
30
did the risk premium on holding Mexican debt, US Treasury Interest Rates

further pushing the domestic currency return on 20

foreign currency assets curve to the right, and 10
putting increased upward pressure on interest 0
rates. The government’s expansionary monetary

91

92
93
94

95
96

97
98

99
00
01

02
19

19
19
19

19
19

19
19

19
20
20

20
and fiscal policies only accelerated the depletion
of their foreign currency reserves, since they led to a fall in domestic interest rates as
those in the U.S. continued to rise. Investors could see Mexico’s financial position was
unsustainable and as a result they prepared themselves for the inevitable devaluation.

Devaluation and Default

By December of 1994, Mexico’s foreign reserves had dropped to approximately US$10

billion which was not enough to even cover the outstanding US$30 billion held by
investors in dollar denominated tesobono debt.6 After a meeting of the government with
the “Pacto”, it was agreed that the ceiling of the band would be raised to allow for 15%
devaluation. Within two days of the devaluation on December 20th, it is estimated that
US$5 billion left the country.7 It was obvious that the new exchange rate was not credible
and on December 22nd the Mexican government decided to float the currency. Investors
left holding peso denominated debt felt betrayed by Mexico’s decision and most
observers were shocked that the float was announced without a coherent macroeconomic
plan to cope with the aftermath. In the weeks that followed, investors fled Mexico, and
nearly brought the country to default.

III. Domestic Policy Reaction

In January of 1995, the Mexican government announced a plan to stem the negative and
inflationary effects of the crisis. The plan included a substantial reduction of government
spending and a contraction in monetary policy, specifically in the amount of credit that
would be available to domestic borrowers. The plan also included an effort to establish a
coherent floating exchange rate regime. This move would ensure an accurate market
value of the peso in the long-run, avoid repeating an overvaluation of the currency, and
help increase export competitiveness.

6
Sachs, et. al.
7
Naim, M.
Realizing that they could not succeed in fixing the crisis on their own, the government
solicited help from foreign entities, primarily from U.S. commercial banks. By February
2005, Mexico had secured a package of loan guarantees and credits that summed to
approximately US$52 billion. This also included an IMF loan of US$17.8 billion, the
largest in IMF history.8

Bailout and Economic Performance Since the Crisis

In securing these loans the Mexican government committed to continue its market-based
reforms and to implement a program of fiscal austerity. The bailout and reform package
were highly effective. Between 1996 and
Mexican % Real GDP Growth
1999, GDP grew by more than 5% per year. In 8.00
January of 1997, Mexico paid back the 6.00
US$13.5 billion in loans from the US 4.00
government ahead of schedule. 2.00

0.00
Mexico’s post crisis reforms came at a severe -2.00
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

cost to the PRI. In 1997, the PRI lost control -4.00

of the Mexican congress.9 Then in 2000, the -6.00
PRI lost the presidency of Mexico for the first -8.00

time in 70 years.10

Monetary Policy

While Central bank autonomy was officially laid out in law in April of 1994, further steps
were taken in the period after the crisis to ensure that it was free of political influence.11
Since the mid-1990s, inflation targeting has been the explicit mandate of the Central
Bank. They have been fairly effective in this task. Inflation, as measured by changes in
consumer prices has fallen from 20% in 1997 to 4.6% in 2004. The Central Bank has
been expanding the money supply since the crisis, and as predicted by the balance of
payments model, nominal interest rates on Mexican treasury notes have declined to
below their pre-crisis level. This trend has greatly diminished the spread between
Mexican and U.S. notes, indicating that the risk premium on Mexican debt has come
down substantially. The nominal peso to dollar exchange rate depreciated gradually from
7.64 in December 1995 to 11.24 in December 2003.

8
Judith Teichman, “The World Bank and Policy Reform in Mexico and Argentina” Latin American
Politics and Society; Spring 2004; 46, 1 pg. 45
9
Ibid
10
“Survey of Mexico: Pride Before the Fall” (October 26, 2000) The Economist
11
Banco de Mexico
http://www.banxico.org.mx/siteBanxicoINGLES/aAcercaBanxico/FSacercaBanxico.html
Fiscal Policy

The federal government has run a primary budget surplus, before interest payment on
public debt, of roughly 4% of GDP from 1997 to 2004. Net of interest payments, the
budget was in deficit of -0.3% to -1.16% of GDP over the same period. The mix of
expansionary monetary policy and conservative fiscal policy has an ambiguous effect on
growth under the AA/DD model.

IV. Conclusion

This paper has attempted to demonstrate how the balance of payment model explains the
dramatic financial shifts, which took place in Mexico during the 1994-1995 economic
crisis. Because of a delay in appropriate fiscal and monetary action on the part of the
government, the country became exceedingly vulnerable to changes in foreign capital
flows. When Mexico had no choice but to devalue the peso, after exhausting the foreign
reserves that had in effect subsidized this delay in government action, the effect on the
peso exchange rate was devastating. Though the balance of payments model cannot at
times explain why individual countries behave in certain ways, it does help us to analyze
what should happen in different scenarios and the consequences of fighting the forces of
the model’s equilibrium.