The Mexican Peso Crisis 1994-95 : Case Study

In the five years to the end of 1994, the Mexican government had built up a reputation for cautious economic management.  Monetary and fiscal discipline was allied to control of wages and prices with the primary aim of reducing inflation to international levels, balancing the budget and creating sustained growth.   By 1994, the strategy appeared to have been successful.  Inflation had fallen from 20% in 1989 to 7% in 1994 and was forecasted to fall to 4% in 1995.   Massive deficits had been eliminated and had been replaced, for the three years up to and including 1994, by a balanced budget.   Economic growth averaged 3.5%  p.a. from 1989 to 1992, although there was a sharp reduction in 1993 to 0.4%, the lowest rate for 7 years.

In January 1994, Mexico acceded to NAFTA as a full member joining the USA and Canada.  Together with membership of the OECD, this appeared to set the seal of international approval on the success of its development strategy.

The Exchange Rate Anchor

The anchor of monetary and fiscal policy for six years had been the establishment of a stable relationship between the Mexican peso and the US dollar by the Salinas Government.  Since November 1991 the peso had been permitted to depreciate by a maximum of Ps0.0004 per day against the US dollar.  By setting a definite limit on the amount of depreciation, this regime encourage business to abandon its traditional preoccupations with devaluations and inflation-hedges and to concentrate instead on "real" business.   In return for a stable peso, labour and business agreed to low wage and price increases.  The stable exchange rate relation with the dollar enhanced the attractiveness of Mexico to foreign (mainly US) investors.  Large inflows of direct investment and portfolio investment occurred.

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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 ...

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