Against these successes must be marked some negative factors, the importance of which are particularly clear in hindsight. First, the current account showed a worrying trend. The deficit had increased each year from a level of $4bn to $23.4bn in 1993. As 1994 progressed, the projected deficit rose to $29bn, or 8% of GDP. Its causes could be traced to a consumer boom and ominously it was financed primarily by short term external debt mostly of a nature.
A second negative factor was that the political background in Mexico during 1994 became volatile. There were two assassinations of major political figures, one of
whom was the ruling party's presidential candidate, and the Chiapas peasant revolt continued to simmer. Foreign capital was becoming uneasy and as a result the foreign reserves had fallen from $30 billion to $6 billion over the year.
To correct the current account deficit, some devaluation was judged necessary. It was hoped that if the extent of the devaluation could be limited to a modest amount, the trade balance would improve and confidence could be restored - without fatal damage to the low inflation objective. Accordingly on 20 December 1994, only 19 days after he had been sworn into office, Mr. Zedillo's Finance Minister Jaime Serra announced an immediate 12.7% devaluation of the Peso and the continuation of the crawling devaluation of Ps0.0004 per day.
Aftermath of Devaluation
The devaluation worked out disastrously wrong. Instead of reassuring markets that the re-alignment was a once-off adjustment, it aroused fears of further and deeper devaluations. The peso proved impossible to support at the new level. By March 1995 it had traded at over 7 pesos to the dollar, a depreciation of over 100% on its level at the outbreak of the crisi s in December. Domestic short term interest rates rose to 42% by January 1995 and the stock market (ZPC) index, which in the past had been butressed by massive inflows of money from foreign pension, investment and mutual funds, dropped 23%. A US investor saw a massive decline in the dollar value of a stock market investment in Mexico and was going to be very hard to entice back to the market. Real wages for Mexican workers fell precipitously in dollar terms.
Causes of the Crisis: Two Views
One view is that the economic "fundamentals" made a devaluation necessary and desirable. The relevant fundamentals would include:
· the 28% rise in the real EER between 1990 and 1993, continued into 1994
· the weakening of fiscal and monetary policy associated with the 1994 election campaign, leading to a surge in imports
· the build up of short term external Mexican debt held by foreigners, mainly US
mutual funds. There was a significant bunching of maturities around the end of 1994.
The above scenario is consistent with the view that the Mexican case illustrates the problem of excessive reliance on the exchange rate anchor strategy to fight inflation. It resulted in an overvalued exchange rate, an unsustainable current account deficit financed by short-term capital inflows. What happened was therefore in accord with theoretical expectations. The proposed devaluation went wrong because it was too small and it got out of control because of the absence of appropriate "flanking policies" i.e. carefully worked-out fiscal and monetary policy measures to ensure its effectiveness. As a result, foreign investors took fright and forced a much larger devaluation, one which would restore Mexico's cost competitiveness.
An alternative interpretation acknowledges the overvaluation of the peso but argues that the market over-reacted. It sees the Mexican case as illustrating the power of speculative capital movements to disrupt stabilisation programmes. Mexican competitiveness could have been restored by any number of possible combinations of domestic inflation and devaluation (the multiple equilibria problem). Thus a 60% devaluation followed by a 50% inflation yields the same improvement in competitiveness as a 20% devaluation followed by a 10% inflation. On this view, market panic resulted in an excessive devaluation (overshooting). This forced a much weaker peso - and by extension a much higher inflation rate - than was objectively warranted by fundamentals. Strong "contagion effects" were evident in other South American and Asian markets, engendered by these same irrational market movements.
Conclusion
Whichever view is correct, it seems generally agreed that inflation: is set to rise from 7% in 1994 to as much as 45% or more in 1995. Investor confidence in Mexico has been dealt a severe blow. Another effect of devaluation was the severe impact of increased import and financing costs on the many foreign companies which had decided to establish in Mexico following the NAFTA Agreement. The depreciation of the peso has damaged trade, as theory would lead one to expect, and it could have created difficulties for NAFTA. Certainly such wild exchange rate fluctuations are not conducive to a healthy growth of trade and factor exchange. Fears have been voiced that the painfully built-up consensus in favour of competition, macro-stability and openness would also be undermined. Certainly it will be re-thought, but the Mexican government appears to be committed to continuance of a reformist, outward-looking strategy.
Sources: R. Dornbusch and A. Weber " Mexico: Stabilisation, Reform and No Growth" Brookings Papers on Economic Activity 253-316 1994