When the stagnation period of the 1980’s and the increase in the Mexican labor force was taken into consideration. It was seen that the economy did not grow over the period from 1981 to 1988, as some industry experts had stated. There was a minute, almost insignificant, growth over the period of 1987 to 1993 of about 3% .The labor force and the population on a hold grew at a rate that was almost the same or more than economic growth, this shows that the per-capita (GDP/Labor Force) income did not increase but may have decreased slightly even. This was followed by pressure on the balance of payment cycle, where exports grew less than the rate of increase in imports. This would prove to worsen current account balances. It can be argued that the minimal economic growth, that was experienced was not growth due to increase in real GDP but was actually caused by discrepancies in the accounting practices of Mexican financial institutions. We shall examine this more when looking from a micro perspective.
There was also another aim the authorities had during this time, which was the expansion of credit. The financial sector also experienced some levels of liberalization, which acted as an encouragement to increase the supply of credit; lending and borrowing rates were freed, the forced channeling of credit was abolished, and bank reserve/liquidity requirements were abolished. The government issued short-term instruments called ‘Tesobonos’. These instruments will prove later to be a problem. The Mexican authorities had several positive signals that somewhat encouraged the profusion of credit which ranged from improved expectations about the economy presently to where it was projected to go. There was an improvement in the stock market, availability of debt instruments, favorable debt condition (there was a reduction in the public debt) etc. During the period 1987 – 1993, there was a reduction in public sector credit of 14% of Gross Domestic Product to 2% of GDP. This reduction facilitated a shift in released funds to the Private sector and this was in keeping with Government’s desired aim to shift economic activity to the Private sector away from the Public sector. There was the abolition of direct lending, as this proved inefficient for the economy.
Problems would arise, for the banking systems and the financial sector on a whole, out of the massive expansion of debt that occurred.
Many years of financial suppression caused a lack of development of very important financial skills such as credit and market risk management. The question I have about the problems is; were these problems caused by crisis? Alternately, were they the cause of the crisis? During the body of this paper, we will see that there was a massive banking sector crisis arising. In order to find out when exactly it occurred we will examine.
The major role of the banking sector in the 1994-1995 crises has been somewhat unacknowledged. This may have been because there were improper accounting practices, as above-mentioned, that may have led to misleading figures, especially in the financial ratios that is, (ROE, ROA, capitalization ratios), that caused the authorities to think, incorrectly, that there was no real cause for concern. What must be stressed is that accounting practices were not the only thing that may have led to the banking crisis. The banking crisis was almost multi-dimensional. There was the expansion of credit followed by improper management of this newfound freedom of credit extension and then there were the accounting discrepancies that hid the problems ensuing. A mouthful, but we shall get a little bit more in-depth. Let us look at the incorrect practices.
The Mexican financial system was nationalized after the crisis of 1982. Interest/exchange rate controls were re-introduced. Certain credit ceilings were adapted. In 1988, the government issued new financial instruments in the form of banker’s acceptance that really were short-term letters issued by companies, which were guaranteed by commercial banks. Overall, deregulation of the banking sector and of financial markets increased capital inflows and gave banks easier access to credit, creating rapid credit expansion. This is where the problem started as banks became increasingly vulnerable because of highly leveraged transactions. There were improper screening practices, credit volume excesses. The lack of prudent risk undertaking was also apparent. Short-term loans were financed or rolled over into long term loans, however the credit crunch caused a sudden halt to these practices which led to the sharp increase in non-performing loans in the financial sector. There was the occurrence of a lot of short-term borrowing and long term lending done by the financial institutions.
The Mexican banking system was unmistakably worsening from 1992 period onwards this was however not a particular concern of the central bank. Bank of Mexico, as it had felt that adequate measures were in place to safeguard the viability of the banking system.
The question that must be asked here is; what was the cause of this substantive boost in credit? We had mentioned before that the government had abolished reserve/liquidity requirement reserves. In addition to this, banks were hastily privatized. Several banks were purchased without their owners proceeding to their proper capitalization i.e. banks were bought using loans which were taken out from those same banks that were being purchased thus no new capital, thus the equity presented was actually liabilities.
The expropriation of the commercial banks in 1982 contributed to their loss of a substantial amount of human capital during the years in which they were under the government. With these, official’s institutional memory migrated as well; there was an increase in the risk of moral hazard, extensive risk undertaking excused by implicit/explicit insurance, as there was the situation of unlimited backing of bank liabilities; there were no capitalization rules, based on market risk. This encouraged asset-liability mismatches, insolvency risk, which in turn led to a liquid liability structure. There was no real supervision of the banking system and this led to an almost overwhelming impact caused by the cataclysmic influx of portfolios of banks. What little regulation that was in place did not have the necessary manpower to go in to institutions to uncover the malpractices of most of these financial institutions. Some bank heads was politically motivated and appointed. There was substantial expansion of credit from the development banks. As of December 1990, foreigners were obliged to purchase local (short-term) government debt and finally as we had mentioned before there was an issuance of a short-term, peso-denominated financial instrument by the government called a ‘TESBONOS’.
In closer examination of the accounting discrepancies between international standards and Mexican practices we saw that there was a recommended capital ratio of 8% that was somewhat superseded by the Mexican economy under their present practices. However, the Mexican authorities had a definition of what a non-performing loan was, that was somewhat different from international standards. What was considered a non performing loan in Mexico was the portion of the loan that was not repaid, whilst international standards stipulates that all of the loans even the part that is paid should be considered non performing if there was non payment after a certain stipulated time period usually 90 days by international standards. What this caused was an inflated capital ratio which when the international standards were applied to these conditions it was seen that Mexico fell unacceptably below the recommended standard.
Another aspect of the problem Mexico faced was that during the period of privatization of banks investors paid enormously high prices for these banks, some estimates have set the prices has high as 3.5 times the book value of these companies and thus with the ‘new bankers’ immediate need to recover their investments they undertook risky ventures. Banks disbursed large amounts of credit without the necessary level of adequate and stringent credit analysis needed. They were also aware of certain problems potential borrowers would have in repaying these loans and thus made special arrangements to facilitate these individuals or corporations. This most recent point puts us to a very important conclusion as to why it was wrong of the authorities to think that adequate regulations were in place to prevent inevitable catastrophe. Additionally; Bankers had found ways of circumventing regulation (which some saw as just plain ‘red tape’) to facilitate further credit extension thus when the peso devaluation of late 1994 had occurred, most of the authorities, who were downplaying the impact on the banking sector that this would have, were surprised at the extent of exposure the Mexican banks were experiencing.
The banking sector was, through the massive expansion of credit and the privatization of banks, experiencing an influx of credit. There, also, was not a proper regulatory framework in place, this maybe due to the fact that these banks were for years owned by the public sector, so the necessary expertise were not in place to exercise prudent screening of potential borrowers and excessive risky business was acquired by these lending institutions. Thus, was the banking sector not due for a crisis eventually, considering the apparent situation? Additionally, however, there was the peso crisis which would prove even more detrimental for the sector as most of the loans were under foreign currency arrangements thus when the peso fell in value most borrowers, expectedly, defaulted on their loans. Even though most banks were able to cover their exchange-risk there were the borrowers which, as mentioned, had taken foreign denominated loans and thus were unable to service their own loans thus what occurred for the banks was the transformation of foreign exchange risk to credit risk.
The main impact on banks came through devaluation of interest rates and inflation where increased inflation and interest rates parallel with a reduction in real income proved most borrowers unable in the servicing of their loans. In essence, we see what the real cause was for the crisis. Yes there was political unrest, there were also bad economic policies but what lies at the root of all this are the malpractices of these Financial Institutions which were mostly focused on increasing there asset base whilst total disregard was in place for their liabilities. The banking sector’s woes were due to; the frequent occurrences of non-performing loans, with other potential loss sources, mainly exchange rate, playing only a minimal role.
However there is one point that must not be ignored, as in the case of Jamaica, Mexico had a frequent occurrence of conglomerates being formed and hence there was the practice of ‘Conglomeratism 1’. There was the case where many Mexican bank directors were issuing generous loans to companies they either had owned by themselves, or owned by the banks. There was the practice of “connected lending2”. With these practices most risk were undertaken not from prudent management but from cronyism.
The Macroeconomic Feedback of the Credit Expansion
Mexico's expansion of credit had turned out very impressive numbers. Between the periods December 1988 to November 1994, credit from local commercial banks to the private sector almost tripled, at a rate of 25% yearly.
In close examining underlying trends: credit card liabilities had a growth rate of 3% yearly, direct credit for consumer durables grew at 67% annually, and mortgage loans at an annual rate of 47 %, these figures are all in real terms.
External credit flows to the private sector increased dramatically from -$193 million in 1988 to $23.2 billion in 1993. There was however, a decrease to $8.9 billion in 1994, but that decrease was more than compensated by the more than 50% fall in the international reserves of the Banco de Mexico. Therefore, the total use of external resources in 1994 was $27.8 billion. The total external financial flows to the private sector were also substantial: $97 billion for the period 1989-1994.
The indecorous attraction of foreign resources coupled with the almost inappropriate liquidation of a substantial amount of government debt, and moral hazard nurtured an increase in private aggregate demand that contributed to the catastrophic increase in the current-account deficit. The financing of this deficit was undertaking, in large part, by short-term capital. The growing external deficit was combined with the commitment, as mentioned earlier, to contain the exchange rate within an ever changing but relatively strict range.
For majority of the period, the exchange rate remained at the appreciated level within the set range, as domestic interest rates attracted short-term capital, banks and private firms went overseas to acquire funds, and thus overseas currency poured into the local stock market. The central bank remained receptive to the demand for currency and in that endeavor partially sterilized inflows or outflows of foreign exchange, allowing international reserves to increase or decrease as so desired. Due to the surplus of dollars, the amount of reserves steadily increased, up to the unstable period before the vote of the U.S. Congress on NAFTA, when reserves decreased for a short time. After the NAFTA vote was approved there, was a continuance of the increase in reserves and continued to increase up until the political unrest of 1994.
There was an increase in the deficit in the balance of trade by almost 6% as a percentage of domestic income over the period, explainable up to 81% by the rise in private investment. However, a substantial portion of the increase in private investment went into economically futile projects, thus contributing to the uncontrollability of the current-account deficit. Examples of some of those undertakings were highly leveraged toll roads, or non-serviceable home mortgages, or some non-banking institutions, which invested with low or negative returns, which received financing from development banks. Some of the credit went into the financing of dubious enterprises or the hugely levered purchase of bank shares, or went to non-collateralized loans.
Thus what we are seeing is, what can be considered, an almost textbook occurrence of excessive indulgence in credit, spending, and a large short-term debt. This coupled with the vulnerability of a fixed exchange rate set the stage for the 1994-1995 catastrophe. The emphasis should be placed on the potentially wavering effects of short-term debt, since foreign direct investment, portfolio investment, foreign-currency securities offered by commercial banks and their credits, and foreign deposits at commercial banks tend to display some levels of stability. This piece of information is useful to highlight and refer to the vulnerabilities related to a fixed exchange rate system, most notable when it does not occur with the automatic stabilizers of a currency board.
Whilst the almost fixed exchange rate did perform its duties by steadily stabilizing prices, in retrospect the Mexican authorities can conclude that it also became increasingly unsustainable within the economic environment that existed which was one of an ever-greater vulnerability and exposure to a speculative attack.
Sharply higher real interest rates in the United States in the second quarter of 1994, a considerable but still orderly depreciation of the peso prior to the December 1994 debacle, and the aftermath of the assassination of a presidential candidate and other unfortunate political events poured gasoline onto already burning coal.
The peso’s reduction in value led to several damaging effects; inflation and interest rates increased drastically, the economy came under increased pressure, the pressure associated with servicing debts denominated in both local and foreign currency increased, and banks' capitalization ratios fell.
Analysts have argued that the crisis had less to do with a minimal savings rate or an overvaluation of the exchange rate, but was better explained by the massive credit expansion which occured. It can be further argued that this credit expansion was not facilitated by prudent judgment in proper risk undertakings.
Crisis Reexamined
We must clarify the argument here; there is nothing wrong with all the factors examined above. A usual opinion is after a boom there will be a bust. In Mexico’s case, there was exactly a boom before their bust. What caused Mexico’s collapse was a kaleidoscope of bad policies, which really were not bad policy just measures in place at the wrong time; if we look at it closely, we would see what really was the problem.
We had said that during the last years of the 1980s Mexico had experienced a period of stagnation thus reform was inevitable. However, the opening up of the sector may not have been the right approach, the real reason behind this is somewhat dubious, was it a political decision based off external factors or influences. It was alleged that Mexico had come under increased pressure from its major trading partner. It was interestingly, everybody’s major trading partner, for the exchange rate mechanism that was in place at the time and was somewhat coerced into the devaluation of its allegedly overvalued dollar. Why was the Mexican economy such a treat to the United States? Most currencies seem as if they have to be in line with what the United States thinks it should be. We can see that in recent time the US tried to pressure Japan to allow its currency to revalue as it is causing problems with US exports. All that’s being said here is that the Mexican government may have not reacted to its problems properly by adjusting its exchange rate to suit the US’s position.
The later point has brought me to an interesting thought concerning these Multinational organizations, which are geared towards providing a ‘Road Map’ to sustained economic development for supposing underdeveloped or developing countries. The multinationals I speak of are the International Monetary Fund (IMF) and the World Bank. My problem lies here, if we check the history of all crisis situations we notice that there are two inter-connected occurrences when there is a crisis; (1) More than 90% 3 off all financial crises are experienced by developing countries (2) Most of these countries that experience the collapse tend to have just or in recent times implemented some of the Multinational company’s policy recommendations. Further to both points, when these countries experience a financial crisis they take additional recommendations, almost non-sensically, from these Multinationals. The reason for this being; amongst the requirements to get assistance from them, and interestingly this assistance is usually under unfavorable financial terms.
However, in our continued examination of the banking sector we will see the increased vulnerability caused by the malpractices of the heads and managers of these banks to undertake high-risk ventures. Data has show that there has been a steady increase in the level of non-performing since 1992. Several banks had experienced insolvency problems and had to be assisted by the government. Most notable of these troubled banks were Bital, Banco Mercantil del Norte, Banco Union and Banca Cremi, which from an assets perspective were responsible for approximately 9% of the total banking sector or about 11% of the commercial banking sector.
The Way Forward.
What really are the aims of an economy after a financial crisis? However, the most fundamental question is; how can these aims be achieved? Interestingly another questions must urgently be asked also; who will pay the price? The government, through the public and private sector, has to adopt stringent policies to tighten up the economy. They need to get rid of waste in the form of excess, usually meaning idle liquidity, tighten up regulations and get rid of the loopholes. This may sound plausible but this has to be achieved whilst not throwing the economy and the financial sector back into repression. There must be a tilting towards transparency. However there must be a distinct line between regulation and ‘Red Tape’. The Mexican government has had a notorious history for corruption and mismanagement and this will not help in charting the way forward. Another important point is the government cannot adopt policies that are not compatible to its economic environment. I speak specifically of adopting policies that are recommended by the IMF or the world bank, as in the case of the reaction to the South Eastern Asian (SEA) crisis, where the government of those countries adopted IMF recommendation which sent the economy deeper and deeper into their already worsening situation. Confidence cannot be restored through massive closures of weak or failing institutions, as this will cause panic what happen to the funds of those poor depositors. That being said what was Mexico’s reaction.
What are the problems of a financial sector crisis? They include high inflation, high exchange rate, low deposits in deposit taking institutions along with a deepening current account deficit, low international reserves, failing institutions etc. Measures that are put in place will have to address all these concerns. Liberalization without proper facilities for maintenance of a proper regulatory framework will prove detrimental. The government of Mexico had sought assistance for the Clinton Administration; this help was forthcoming in the form of an assistance package of U.S. $52 billion. There was a stark difference in the reaction of regulators to the 1994 – 1995 crisis against the crisis of 1982 as after 1982 the government literally shut down the economy in the form of policies, which included suspension of payments on foreign debt, exchange controls, and the nationalization of banks among other things. However, in late 1994, after the crisis, the government reiterated its commitment to structural reform, maintenance of liberalization was evident. The government undertook an agreement with the private sector and the relevant authorities in early 1995 called the ‘Pacto’. Under this agreement, there were adjustments to administered prices. There were changes to minimum wages and there was an agreement with entrepreneurs to limit price increases due to the fluctuating exchange rates. Since there was an inflation projection of 19%, the government introduced an income tax rebate to assist the reduction in real wages that would have been caused by the inflation.
In response to the concern of capital flight Mexico, like Argentina, increased domestic interest rates, this however brought on additional concerns that banks borrowers may not be able to meet their obligations. Here we are branching into the macro effects on the crisis.
As in all countries having to deal with a crisis there are certain fundamentals that have to be considered however as with all desires there were some constraints. The Mexican government faced certain problems in designing programs to deal with their ensuing loss in confidence in the financial sector coupled with tight monetary policies, which had a micro impact on the banking crisis. The Mexican government had an aim to use non-inflationary measure to deal with the crisis. The restructuring program recommended by most analysts should take into consideration; (1) the cost of the restructure, as above mentioned (2) where the responsibility should lie, and (3) is the growth of failing institutions controlled.
Mexico had a capital injection plan that was somewhat similar to the path taking by Argentina in dealing with their financial crisis of a similar nature however Mexico had distinct measures put in place to deal with their policies of preventing banks from expanding bad credit whilst they were in their restructuring phase. This came in the form of stringent supervision of risky banks to force them into reducing their capital and to restructure their ways of operating and the indexation of loans.
Additionally there were further measures taken by the government to reduce the risk of an inevitable run on the banking system which was plagued with the problem of bad debts and manifesting from self-dealing and fraud. The government in early 1995 instituted a banking fund for the protection of depositor’s savings, which was eventually called Fund for the Protection of Savings a.k.a. FOBAPROA. This institution is somewhat similar to FINSAC of Jamaica and the U.S.’s resolution trust company. However, as with Finsac, Fobaproa faced the problem of the every increasing cost of operating. The Mexican administration, in its effort to deal with this problem; the bad debt was converted into public debt and the reason behind this decisions was the argument put forward by some analyst that if this was not done then there would have been extensive pressures on the domestic banking industry. It must be argued however that the public cannot be held responsible for the bad management practices of a few institution heads. Analyst have put forward the argument that proper measures should be put in place to make these heads pay or face prosecution, as in the case of Enron in the United States where a few of the ceo’s of the failed energy giant were giving jail time for illegal accounting practices.
In concluding we see that a deliberate attempt was made to offer a qualitative analysis of the crisis Mexico faced and the measures that were put in place. The underlying problem involved in all countries experiencing or who had experience a crisis; South East Asian countries, Jamaica, Argentina all in the 1990s, United States in the form of the energy giant Enron (2001), and the Dominican Republic (presently), are accounting mismanagement practices. The continued maneuvering of regulation to expand asset base carelessly and the undertaking of high-risk ventures without prudent investigating will always lead to disaster. Regulations that are put in place must be above board transparency is a must. The cost to the sector is too enormous to allow the attitudes of a few institution heads as the cost of bailing out a sector usually rests on the shoulders of the tax-payer as in the case of Jamaica where the cost to the economy of the financial crisis is estimated at 353 billion dollars which has been converted from private debt to public debt.
