The 1994 Mexican Currency Crisis

Past and Present

With a steady flow of oil and other exports, the Mexican economy enjoyed steady economic growth and relatively low inflation rates from the mid-1950s to the early 1970s. With the surge in oil prices that occurred during the 1970s, Mexico realized a windfall in oil export revenues. Forecasts predicted that oil prices would continue on their upward spiral, reaching $65 a barrel during the 1980s. Anticipating continued growth in oil export revenues, the Mexican government adopted generous fiscal policies to develop the economy and infrastructure.

Cartel members have an incentive to cheat to gain extra revenues, and OPEC was no exception. Initially, Iran and Iraq exceeded their quotas to help finance their war with each other, and soon other OPEC members joined in. In addition, alternative oil sources and other forms of energy became commonplace, so that by the early 1980s spot market oil prices were falling well below the official OPEC world price. Oil prices, which had peaked in the mid-$30 price per barrel range, collapsed, falling below $20 a barrel. The revenue that the Mexican government had anticipated from oil revenues was severely diminished. The reduction in revenues, coupled with rising interest rates throughout the world and the large Mexican fiscal budget deficits resulted in a debt crisis. In August 1982, the Mexican government announced that it could not meet its scheduled debt payments.

When a severe recession shook the Mexican economy in 1982, the government nationalized the country's banks and imposed severe tariffs on imported goods to protect domestic producers. This was the beginning of a period of economic contraction; real per capita GDP growth from 1981 to 1988 was -2% per year. The government was forced to cut spending on many social and economic programs including education and health care.

In response to economic stagnation, Mexican presidents have taken their economy down the road of economic liberalization during the past decade. The process was started by Miguel de la Madrid and picked up momentum with Carlos Salinas. Under current president Ernesto Zedillo, Mexican economic reforms have continued, but have been hindered by a stumbling economy.

The reform process began by reducing Mexican tariffs on imports from an average of 60% in the mid-1980s to below 20% and falling to zero for many U.S. and Canadian imports by early in the twenty-first century. To encourage trade and price stability, the peso was pegged to the dollar. The government reduced its fiscal deficit while enacting market-oriented reforms such as the privatization of resources and industry, reducing the dominance of the government sector. Fiscal restraint has helped to diminish chronic inflation, which reached 159% in 1987.

After the extremely difficult 1980s, the 1990s began with the first positive economic growth in Mexico in nearly a decade. Trade liberalization led to a jump in both exports and imports. Financial capital returned from abroad and was increasing retained by Mexican citizens saving at home. The majority of the capital inflow taking place in the 1990s was in the form of portfolio investment in the Mexican equity markets. This is a very liquid form of savings that can be moved from the economy almost overnight when conditions change. (1)


(1) In 1980 76% of capital inflows into Mexico were in the form of long-term debt, composed primarily of loans from foreign commercial banks; 26% was in the form of direct investment, while essentially no foreign money was used to purchase Mexican stocks (portfolio equity). In 1993, 64% of capital inflows into Mexico went into portfolio equity, 22% was composed of direct investment, and 14% was in the form of long-term debt.


Despite economic reforms, the Mexican economy is extremely vulnerable to internal and external shocks. For much of the 1980s, real per capita income fell. Presently, Mexico's 92 million people have a lower real per capital income than in 1980. Who can blame the Mexican people if they are becoming anxious about the success of economic reform? At the present time, Mexico provides an incubator to test modern economic theories carried out by policy makers who studied and received PhDs at prestigious U.S. universities.

By opening up its economy, Mexico has left itself vulnerable to the whims of outside forces. In this section, we will take a look at how the flight of foreign and domestic savings in the capital markets contributed significantly to the current contraction of the Mexican economy.

1995 GDP is expected to shrink by 6% in Mexico, causing the number of unemployed to double while inflation exceeds 50%. A devaluing peso, falling equity markets, and crippling interest rates (short-term interest rates have approached 90%) have combined to place the Mexican economy on the brink of a social meltdown.

We will now look at the currency crises which ended the year of 1994 in Mexico. We want to examine the interdependency of the domestic and foreign sectors of an economy. In the case of Mexico, increased dependence on whimsical, fast-moving and profit-hungry capital markets pulled the rug from under the domestic economy. We will also see what it is going to take to get Mexico back on its feet again.

Mexico, "so far from God, so close to the United States"

So goes the old aphorism about Mexico. The integration of the Mexican and the U.S. economies was a major focus of Mexican foreign policy in the early 1990s. Former Mexican president Carlos Salinas accelerated the pace of reform in the Mexican economy. As part of the program to integrate Mexico into the world economy and encourage international trade and increased rates of economic growth, Salinas risked a good deal of his political capital on the approval by the United States and Canada to include Mexico in the North American Free Trade Agreement (NAFTA).

Members of NAFTA agree to completely eliminate all barriers to trade such as tariffs within fifteen years of signing the trade accord. By accepting Mexico into NAFTA, the United States was sending the message that Mexico was ready to take its place on the world stage. In return, Salinas would deliver a maturing economy with good fiscal discipline and, to encourage international trade, a stable currency.

A volatile currency hampers international commerce as businesses must undertake the added expense of hedging against exchange rate risk in foreign exchange markets. In addition, a widely fluctuating currency (especially a depreciating one) discourages movements of foreign capital into domestic financial markets. The peso was pegged to the U.S. dollar, only allowing for a small trading range (commonly known as a "snake"), at the rate of about 3.5 pesos to the dollar (or $0.28 to the peso). A stable peso eliminated exchange rate risk in business and financial transactions, encouraging participation by U.S. investors in Mexico's consumer and financial markets. The dollar was a logical choice for Mexico, not only for geographic reasons. About 70% of all Mexican international trade is carried out with the United States.

In the early 1990s, the Mexican economic plan led to a huge inflow of foreign money through the capital account. Between 1990 and 1993, foreigners sent $91 billion into Mexico, but rather than purchasing long-run direct investments in Mexican industry, two-thirds of the money was used to buy highly liquid Mexican stocks and bonds. As a result, the majority of foreign money entering Mexico during this time period could exit almost overnight.

The high value of the peso in relation to the dollar acted as a subsidy to Mexican consumers. With a windfall purchasing power, Mexican consumers and industry went on a buying binge of imported goods, primarily from the United States. Economic policy makers worry when their country's current account trade deficit reaches 3% of GDP, since high trade deficits eventually result in a currency depreciation. Mexico's current account trade deficit rose from 6.5% of GDP in 1993 to 7.7% of GDP in 1994. The increased consumption was paid for by a reduction in domestic savings (2) rates from 22% of GDP in 1988 to 16% by 1994. By keeping the value of the peso high, and thus import prices relatively low, Mexico was sacrificing domestic production in favor of imports.


(2) Total domestic savings is the sum of public (government) plus private (consumer and business) savings.


During this period of nominal exchange rate stability, the real exchange rate of the peso had increased significantly. The nominal exchange rate measures one currency in terms of another (in this case the peso's value was pegged to the dollar). The real exchange rate is an indicator of the purchasing power of the currency. Given a fixed nominal exchange rate, a change in relative inflation rates leads to a movement in the real exchange rate. The formula for the real exchange rate is:

% change real ex. rate = % change nominal ex. rate + % change in domestic prices - % change in foreign prices

In the early 1990s, the nominal value of the peso was pegged to the dollar. At the same time relative inflation rates in Mexico were higher than in the United States (roughly 30% greater from 1991 to 1994). The effect was to increase the prices of Mexican-made goods to Mexican consumers while maintaining a steady price on imports form the United States, due to the pegged nominal exchange rate. With the real peso appreciation, Mexican consumers enjoyed an increase in purchasing power in terms of U.S. imports. With domestic incomes rising along with inflation and import prices constant, the Mexican government was subsidizing the purchase of imports from the U.S., which were falling in real terms. Consequently, Mexican consumers would substitute consumption in favor of relatively cheaper imports, increasing the current account trade deficit.

If 1994 were a fish, Mexico certainly would throw it back. The year started out promising, on January 1 when NAFTA was expanded to include Mexico in the free trade zone. But while the Mexican leaders looked to the benefits of free trade, a previously unknown guerrilla group known as the Zapatistas, led by a masked, pipe-smoking former university professor calling himself Subcomandante Marcos, seized a half dozen towns in the poor southern state of Chiapas. Subcomandante Marcos denounced NAFTA as a "death sentence" for Mexico's Indian population, including the indigenous Maya of the Chiapas region. Increased social unrest in Mexico culminated with the assassination of President Salinas' PRI successor, Luis Donaldo Colosio, a popular figure in Mexican politics.

The 1994 election went as the PRI desired and Salinas passed the presidential torch to the PRI candidate, Ernesto Zedillo. However, before the year ended, the intrinsic vulnerability of Mexico's economy was exposed as the Mexican peso/U.S. dollar exchange rate collapsed. There were several major causes of the exchange rate collapse of the peso:


(3) Until the political and economic events of 1994, Mexico could maintain the fixed peso value despite the current account deficit. In the capital account, foreign savers seeking high rates of return in Mexico's soaring equity markets and businesses with direct investments in Mexico kept the peso demand strong. The increased supply of pesos in the current account was offset by higher demand in the capital account.


(4) During this period the Mexican government issued large quantities of short-term, dollar-indexed securities known as tesobonos. Tesobonos were used to help finance government activities and were dollar-denominated to ensure buyers a rate of return that avoided exchange rate risk.


A Graphical Look at the Peso Collapse

As shown in Figure 7-IV.1, the peso was fixed in value in relation to the dollar in the early 1990s. The graph shows the peso pegged to the dollar at a exchange rate of one peso to $0.28 (which equals 3.5 pesos to $1). Note that we show the quantity of pesos in world foreign exchange markets on the horizontal axis and the $/peso exchange rate on the vertical axis. In the beginning of 1994, it took $0.28 to buy a peso's worth of Mexican goods.


After nearly a decade of nonexistent economic growth, the Salinas-led surge in the Mexican economy occurred in the early 1990s. Economic growth averaged 3.1% annually, a respectable rate, although slow in comparison to other developing economies. Increasing rates of economic growth, coupled with the strong exchange rate of the peso (which kept U.S. imports relatively cheap and Mexican exports relatively expensive) caused a significant current account trade deficit. With over 70% of Mexico's imports coming from the United States, the supply of pesos was much greater than the corresponding demand in the current account.

As Figure 7-IV.2 displays, the Mexican current account trade deficit of the early 1990s led to a net increase in the supply of pesos in foreign currency markets. By itself, the current account deficit puts downward pressure on the peso's value. Offsetting effects occurred in the capital market, where the demand for pesos remained strong in early 1994.
As mentioned earlier, there was a substantial demand for pesos from foreign savers looking for higher rates of return in Mexico's equity markets and an increase in direct investment by businesses in Mexico seeking access to the growing Latin American consumer markets. The capital account had a surplus due to the scorching rates of return being earned on Mexican financial assets in the early 1990s. Consider 1993, when investors who purchased Mexican stocks earned nearly a 100% rate of return, doubling their money in one year.


Figure 7-IV.3 shows the balance of the supply and demand for pesos in foreign exchange markets in early 1994. Despite the significant supply of pesos resulting from the current account deficit, demand in the capital account remained strong. The Salinas government had little trouble maintaining a stable value of the peso in relation to the dollar.


The Mexican current account deficit was roughly balanced out by the capital account surplus. As noted, the Mexican government had a large surplus of dollars to use in foreign exchange markets to purchase pesos when the demand faltered. When there was downward pressure on the peso, the Mexican government could use its ample dollar reserves (nearly $29 billion) to buy pesos in foreign currency markets.

The United States Federal Reserve Fights Potential Inflation

After the recession of 1991 and the near catastrophe in the U.S. banking system resulting from the Savings and Loan fallout, the Federal Reserve Board engaged in expansionary monetary policies, eventually reducing U.S. interest rates. Falling interest rates helped to revitalize a comatose banking system while preventing the extinction of the U.S. savings and loan industry. A reduction in the federal budget deficit in 1993 resulted in significant reductions in long-term interest rates, stimulating consumption and investment. By 1994 the U.S. economic growth rate was soaring. Capacity Utilization and other inflationary indicators were reaching a danger zone of potentially resurgent inflation. As a result the Fed slammed on the monetary brakes, raising the U.S. Fed Funds interest rate seven times over the course of a year.

Rising U.S. interest rates increase the attractiveness of U.S. assets, such as bonds, to savers. The higher U.S. rate of return coupled with the political uncertainty present in Mexico in 1994 initially caused Mexican savers to flee Mexican markets in favor of U.S. assets. U.S. money fund managers quickly followed. True to form, money managers who controlled huge amounts of U.S. savings held in Mexican assets, overreacted and raced each other to flee the Mexican market. As the greed of 1993 turned to the panic of 1994, the value of Mexican stocks and bonds plunged.

As savers left Mexican asset markets, the demand for pesos in international currency markets dried up. In addition, by December 1994 President Zedillo's finance minister had nearly depleted the reserve of dollars used to buy pesos in order to maintain its fixed value. As shown on the graph to the left (Figure 7-IV.4), the continued increase in the supply of pesos due to the current account trade deficit, coupled with the reduction in demand for pesos, swamped the currency markets and President Zedillo had no choice but to float the peso, allowing it to depreciate.


Consequences of the Peso Depreciation

By the fall of 1995, the peso had depreciated to roughly 8 pesos to the dollar ($0.12). Economic theory tells us several outcomes are likely when a country's currency falls as far as the peso in so short a time period. This is especially true for a country like Mexico where international trade represents an important part of GDP.

The statistics confirm Mexico's situation.

  1. Inflation is exceeded 50% in 1995.
  2. As a result of the cheaper peso, Mexican exports increased by 33% during the first eight months of 1995 in comparison to a similar period during 1994. Overall, the current account deficit became a surplus by the end of 1995. The effect of the peso devaluation is especially pronounced in trade with the U.S. where Mexico engages in almost three-fourths of its international trade.
  3. The Mexican government chose to put on the economic brakes to prevent a further inflationary spiral. 1995 GDP growth is expected to fell by -6% as a result, and the total number of unemployed has doubled within the past year.

The long run results of NAFTA

In this part of the discussion, we will try to take an objective look at the economic effects of NAFTA on the United States and especially Mexico. The linkage between the Mexican currency crisis and NAFTA is weak at best. As discussed above, the peso collapse resulted from non-NAFTA factors such as capital flight, real exchange rate appreciation of the peso and a huge current account trade deficit.

The U.S. economy is twenty times the size of the Mexican economy. Only a small part of international trade conducted by the U.S. is with Mexico. To make NAFTA more politically palatable to its opponents in the U.S., the Clinton administration set up a program to directly assist U.S. workers who lost their jobs as a result of NAFTA. As you know from the material covered previously in this class, increased trade between the U.S. and Mexico could lead to the loss of some American jobs as consumers and firms substitute in favor of cheaper Mexican imports.

By the summer of 1996, only 117,000 Americans had signed up for the benefits offered to workers displaced by NAFTA. In comparison, 1.5 million U.S. workers lose their jobs each year from factory closures, slack demand and corporate restructuring. Contrast the jobs lost to the 2.8m new jobs created each year in the United States, and NAFTA appears to have no widespread macroeconomic effects on the U.S. labor market.

One fear associated with NAFTA, was the belief that U.S. firms would close up their local manufacturing plants and relocate into Mexico in search of cheaper labor and possibly more lax environmental laws. However, it is estimated that American direct investment in Mexico has averaged less than $3 billion a year since 1994, NAFTA’s first year. That is under 0.5% of American firms’ total annual spending on plant and equipment. U.S. firms have not made a mass exodus for Mexico, because lower labor costs in Mexico are offset by higher labor productivity in the United States.

In his memorable November 1993 debate with then Vice Presidential candidate Al Gore, billionaire businessman Ross Perot, a protectionist presidential candidate, forecast a “giant sucking sound” as American jobs vanished southward as a consequence of NAFTA. Perot proved wrong. By the Fall of 1997, the U.S. unemployment rate had fallen to 4.5%, the lowest level seen in over thirty years.

Some U.S. firms have increased their direct investment in Mexico, but often to their own benefit. Over the past couple of decades, the U.S. textile industry has been in a steady decline, unable to compete with low-cost imports from Asia. As a result of NAFTA, American textile firms have undertaken joint ventures with their Mexican counterparts to produce goods at a lower cost. Without these initiatives, the U.S. textile industry would have continued its rapid erosion and loss of domestic jobs, but is now able to increasingly compete against imports from Asia.

True, since the implementation of NAFTA, Mexico has moved from a current account deficit to a surplus, but the explanation lies in the tremendous devaluation of the peso in relation to the dollar. The United States already had low tariffs on most of its goods. It therefore did not need to liberalize its markets much; and, even when it did, some favored sectors, such as agriculture, remained protected.

In addition, Mexican trade liberalization had begun in the mid-1980s. In 1985, the country’s business and political leaders, fed up after yet another economic crisis, abandoned decades of protectionism, joining GATT the following year. By 1990, Mexico’s exports were 14% of its GDP , twice as much as ten years before. Although NAFTA took things further, cutting tariffs on American (and Canadian) goods from 10% to 3%, trade between Mexico and the United States was booming long before 1994.

Perhaps more significant is the improved political relations between the U.S. and Mexico that have resulted from closer economic ties. Historically, the U.S. and Mexico have not been the closest of friends despite their geographic proximity to each other. NAFTA has encouraged a more cooperative political as well as economic relationship between the two countries. For example, after the peso crashed in 1994 sending the Mexican economy into a severe recession, President Clinton rushed in, putting together a $50 billion international rescue package. The money was needed in a time of economic distress in Mexico and as Mexico's economy improved, it quickly repaid the loan in full. Without NAFTA, it is doubtful that the U.S. would have made any money available for Mexico to borrow to help their burdened economy.

It is difficult to take Mexico's perspective about NAFTA when recognizing the severe recession that followed shortly after Mexico joined the trade agreement. As noted earlier, the Mexican recession was not a direct result of NAFTA, but some of the policies implemented by the Mexican government in the early 1990s to promote Mexico's entrance into NAFTA, did contribute to the recession. By promoting trade between the U.S., Mexico and Canada, NAFTA did help boost Mexico's exports in the region, providing a silver lining during the Mexican recession. Soon after NAFTA, Mexico had a current account surplus (significantly aided by the peso's depreciation). By 1997, Mexico's recession was over and positive economic growth had resumed.

Copyright 1998, Jay Kaplan
All rights reserved
Last updated January 9, 1998