An Investigation into the Role of the International Monetary Fund in the 1994 Mexican Peso Crisis
Introduction
The devaluation of the peso in late 1994 created economic turmoil throughout Mexico, resulting in the worst recession in over half a century. Today, Mexico continues to make an impressive economic recovery. However, ongoing economic and social concerns include low real wages, underemployment for a large segment of the population, inequitable income distribution, and few advancement opportunities for the largely Amerindian population in the impoverished southern states. This paper will provide a review of the relevant literature to determine the role of the International Monetary Fund in helping Mexico overcome these past challenges to its economic development, followed by a summary of the research in the conclusion.
Review and Discussion:
Background and Overview. Mexico has a territory of 761,600 square miles, making it the third largest nation in Latin America and the fourteenth largest in the world (Mexico, 2003). Mexico has a population of around 92 million people, making it the second most populated country in Latin America (and a major market for US goods and services) (McClean, 1995). Mexico's economy had rebounded from a period of stagnation and had even managed to reduce its inflation rate from 30 percent in 1990 to 6 percent by the end of 1994 ( McClean, 1995). However, the 1995 projected Gross Domestic Product (GDP) for Mexico was reduced from 5 percent to 2 percent as a result of the peso devaluation. Further, there appears to be a distinct pattern emerging between the decline in the nation's economy and the choices made by previous administrations.
Description of 1994 Mexican Peso Crisis. According to Springer (1995), a combination of events -- an increase in US interest rates, political ferment and presidential elections in Mexico, plus capital flight from Mexico which was prompted, in turn, by lax monetary policy during the last weeks of the Salinas administration -- all helped contribute to, and culminated in, a collapse of the peso at the end of 1994. The CIA World Factbook entry for Mexico states that the devaluation of the peso in late 1994 "threw Mexico into economic turmoil, triggering the worst recession in over half a century" (Mexico, 2003); however, the country continues to make an impressive recovery to date.
Role of International Monetary Fund in Mexican Peso Crisis. The International Monetary Fund (IMF) was formed in 1945 with the goal of bringing economic stability and growth to the free world after the devastation of World War II. However, the IMF is not a bank, but is rather a cooperative institution aimed at maintaining currency stability for its 184 members. According to its organizational website, since it was established, the purposes of the IMF have remained unchanged; however, its operations (which involve surveillance, financial assistance, and technical assistance) have developed to meet the changing needs of its member countries in an evolving world economy (2003).
Analysis of IMF Impact. During the annual World Bank-IMF meetings in October 1995, Lawrence Summers, deputy secretary of the US Treasury and former chief economist at the World Bank, claimed that the mission of the international financial institutions "over the past half-century has been to support the developing world's evolution to a market economy." Free-market economists, however, have long believed that multilateral lending agencies hamper economic prosperity (Vasquez, 1997).
The trend to bail out a poor country with funding cannot be stopped once it has been started. In many cases, by approving stand-by programs whose targets everyone knows will not be met, the IMF is participating in a big charade; it is implicitly saying that ... there is a high probability that the country will attain balance-of-payment viability in the near future. For many countries this is not the case and, according to Vasquez: "everybody knows it" (1997). Instead of promoting economic reforms in the developing world, IMF loans have allowed politicians in recipient countries to postpone the introduction of necessary policy change. While the poor people in this nation continue to live in poverty the politicians are spending-- the question is on what. Governments that receive such aid often find it easier to avoid making the politically difficult decisions required by liberalization. Consequently, conditionality provides little incentive to reform. Indeed, as Fred L. Smith Jr. of the Competitive Enterprise Institute put it, the opposite incentive seems to take hold (Vasquez, 1997). Wage and price controls are two such prescriptions consistently employed in Mexico and backed by the fund, especially since the onset of the 1980s debt crisis. It is not unusual for the lending agency to sponsor policies like these, as it freely admits: "in many instances, Fund-supported programs have accommodated such nonmarket devices as production controls, administered prices, and subsidies says the IMF." These "stabilization measures" try to reduce inflation by dictating the costs of goods and services. According to Vasquez (1997), not only does that top-down approach misdiagnose the principal causes of inflation (monetary and fiscal policies), but it destroys people's purchasing power and creates a scarcity of goods. Nonetheless, a certain degree of wage and price controls has been part of many IMF-backed economic plans for Mexico since 1982, beginning with the "Program of Immediate Economic Reorganization" and including the 1995 "Agreement of Unity to Overcome the Economic Emergency. The 1982 stabilization program initially reduced inflation, in no year did inflation drop to IMF expectations. By the time the program collapsed in 1985 and the fund suspended credit, the inflation rate was 63.7 percent, compared with the IMF's projection of 18 percent. The situation in 1995 was similar; there the IMF originally required 19 percent inflation for the year, but the real rate reached 53 percent. Further, while the economic pacts of December 1987 and the early Salinas administration did succeed in cutting inflation, they did so with the help of a stricter monetary policy, trade liberalization, and deficit reduction measures--all of which the Mexican government endeavored to accomplish out of economic necessity brought on by previous policy failures. Controlling inflation becomes more difficult when government officials can use IMF credit to bolster inflationary monetary and fiscal policies. In fact, with that in mind every move the IMF makes to try and help Mexico, the worse the situation seems to get. While the government continues to take the aid being offered, that aid does little to change mistakes that have already been made. Still the research shows that government officials do make correct decisions out of the necessity to bring the economy out of debt. That was certainly true of Mexico in the early to mid-1980s, when structural reforms were not even officially contemplated and, according to Mexican economist Luis Rubio, "everything was done to reduce current spending to as little as possible reminds Vasquez (1997). It is doubtful that Washington would have lobbied for the IMF to bail out a country with which the United States did not share a border and in which U.S. banks did not have so much invested. The bailout of Mexico in the 1980s was almost as much a bailout of US banks as of the Mexican government. It is a shame that IMF-led debt renegotiations allowed Mexico to avoid widespread privatization, which would have been a big step toward resolving that country's crisis. In the end, IMF lending dragged out the economic debacle, and liberalization finally took place only at the close of the "lost decade" despite, not because of, the IMF, stated Vasquez in the (1997) issue of Orbis.
Current Trends and Issues. In the mid-1990s, with IMF help, the Mexican government continued to support money-losing enterprises and an army of government programs that did little to alleviate poverty. Yet another policy promoted by the IMF and endorsed by the governments unwillingness to cut excessive spending was an increase in taxes. Mexico took such advice in 1982 and, despite poor results in that trial, again in 1995, when it raised the value-added tax by 50 percent. While higher tax rates, never known to stimulate investment, aim to close a budget deficit, it is difficult to imagine how a country like Mexico can become prosperous when the government tries to seize even more of impoverished citizens' wealth (Vasquez, 1997). Once again the choice to privatize seems to be the only clear option for Mexico and in it's already poverty stricken state, a 50 percent tax increase will only hinder the recovery process. The worst aspect of IMF intervention, perhaps, is the fund's mercantilist obsession with reducing deficits in a country's current account, which measures the income from transactions with other countries in merchandise sales: trade, services, and investments. The IMF assumes a negative view of such deficits and a positive view of surpluses. According to Todd Robberson, "The $1 billion trade deficit Mexico suffered with the United States for the first half of 1994 turned into a $6.9 billion surplus for the first half of 1995. In an open economy, citizens benefit from choosing the best goods and services at the lowest prices offered either at home or abroad. And as stated by Vasquez (1997), Adam Smith pointed out long ago, countries gain from trade whether or not they experience surpluses, because free trade allows nations to increase their wealth through specialization, improvements in efficiency and competitiveness. Not to mention the acquisition of goods at the lowest costs. If a nation buys more than it sells, after all, it must find a way to finance those purchases. In fact, all wealthy nations, with the exception of England, grew rich by borrowing private capital from abroad. On the other hand, poor countries have not grown rich by relying on subsidies from foreign governments or by adopting mercantilist economic policies. Government policies ultimately proved unsustainable as too low reserves fell to continue defending the exchange rate (Vasquez, 1997). Moreover, the loss of reserves and inevitable devaluation eliminated the government's ability to repay the dollar-indexed bonds coming due in 1995. To make matters worse, Mexico initially devalued its currency by 15 percent rather than move immediately to a free float. According to Vasquz (1997), by setting another arbitrary exchange rate without undertaking corresponding policy measures that could restore confidence--such as restricting spending or credit--the government essentially subsidized the currency's flight. As economist Arnold Harberger noted, that policy was an invitation to what we call one-way speculation (in which the speculator has virtually no downside risk). Those who got their money out at an exchange ram of 3.9 pesos per dollar were clear ... winners in that situation. Mexico's taxpayers, the Mexican people, were again the losers. In the end, there are no clear winners. Vasquez stated in (1997) that the efforts to expand IMF functions exhibit an inherent distrust or misunderstanding of the growth of international capitalism. As one Clinton administration official put it, "It is a whole new set of priorities. Forget everything you learned about how to help developing nations. Now it's fidelity first." As a result, there has been an intense focus on Mexico-style crises, which are believed to destabilize the international financial system. Nevertheless, investors always discriminate among markets, as the post-peso-devaluation scene proved. Indeed, Mexico's currency instability posed no more than a modest threat to global finances--a conclusion even an IMF report reached by August 1995.
Future of Mexican Peso. If it wishes to develop economically, as Vasquez (1997) sees it, a country as poor as Mexico should not be an exporter of capital as it has been under the IMF-backed program. In the final analysis, Mexico must honor its debt by running current-account surpluses. However, the best strategy to achieve that end is to grow itself out of the debt, rather than compounding the damage of past policy mistakes by following the fund's antigrowth measures. The more money that is leant to this already poor country the worse off Mexico will be because of it. Mexico has the ability to regain a more stable means of government capabilities without the IMF, the future is in how officials go about handling this crisis and their means to inevitably handle the next. Mcquerry's (1999) research shows that the Temporary Capitalization Program (PROCAPTE) was targeted to help banks increase their capital-to-assets ratio above 8 percent. Some banks already met this requirement but others did not. PROCAPTE allowed banks needing additional capital to issue five-year convertible bonds, which were purchased by FOBAPROA. The banks that were participating agreed to surrender their institution to banking authorities in the event they were unable to convert their debt into equity capital. Consequently, PROCAPTE became a short-term program that contained strong incentives for participating institutions to act expeditiously to facilitate their capital ratios. Nevertheless, the program did not function as it was fully intended: "The market considered participation as a sign of weakness or as a prelude to intervention. . . . Because of the negative public perception of PROCAPTE, banks attempted to avoid participation by increasing their capital on their own. However, many banks were unable to raise capital during this period (McQuerry, 1999). As a result, additional measures were required following PROCAPTE (Mackey 1999, 191).
The second program was the Loan Purchase and Recapitalization Plan, which exchanged delinquent loans held by banks for government-issued bonds. The program is often referred to as FOBAPROA, after Fondo Bancario de Proteccion al Ahorro, the deposit insurance agency that administered it. The basic purpose of the program was to clean up bank balance sheets and improve asset quality at virtually no immediate cost to the government. The bonds issued to the banks were ten-year, zero-coupon bonds. Interest payments, based on domestic treasury rates, were payable at maturity. According to McQuerry (1999), as a condition of this program, bank shareholders injected one peso of new capital into the bank for every two pesos of bad loans transferred to the FOBAPROA trust. Banks were also required to set aside reserves valued at around 25 percent of the total debt transferred, but they could not profit from the transaction because the bonds were not tradable.
Other programs specifically targeted mortgage holders, agricultural borrowers, and small and medium-sized business. These programs were successful in preventing even larger increases in banks' past due portfolios even though they may not have been the most effective channel to benefit the debtors themselves (Mackey 1999). Not much is either being done or even being suggested to help the Mexican people who are the ones that are not even being affected by the bank's small successes. Probably the single most important traditional indicator for bank soundness is capitalization, measured here by net capital over risk-weighted assets. According to Mcquerry (1999) a bank's capitalization level is extremely important because it measures how prepared the institution is for unexpected developments, like the peso crisis, when borrowers are unable to make payments or bank assets decline in value. Peso figures are calculated in dollar terms using the exchange rate on December 31, 1998 (US.$1:9.9 Mexican new pesos). One U S dollar to approximately every ten Mexican pesos is a staggering figure meant to show just how much the peso is not worth. According to LaFranchi (1999) already, like millions of Russians, many Mexicans keep dollars as a hedge against the peso's infamous instability, reflecting a global trend. Since 1994, more dollars have circulated outside the US than in it, a form of interest-free borrowing for the Treasury that saves US taxpayers over $10 billion a year, according to Federal Reserve specialists. As NAFTA reaches its fifth anniversary, and the launch of the euro puts monetary union in the air, Mexicans are talking about moving ever closer to - the US dollar. Ideas range from pegging the peso to the dollar, to creating a North American currency unit, states LaFranchi (1999) to simply bidding "adios" to the peso and adopting the greenback. For Mexico the need to do away Mexico's "recurring crises" typically have occurred at the changing of the guard between two six-year presidential terms - as with the peso's last big crash in 1994-95, when the Mexican currency lost 60 percent of its value in relation to the dollar. Along the lines of Franchi's (1999) research monetary specialists say Mexico could follow one of three distinct paths if it chose to "dollarize" its economy officially:
· Peg the peso to the dollar, setting a peso-to-dollar equivalency as in Argentina and Singapore;
· Push for creation of a "North American" currency to be used by the NAFTA countries;
· Simply allow the dollar to circulate as the country's currency, as Panama and, to a certain extent, Cuba have done.
The disadvantage for Mexico would be a loss of monetary autonomy, analysts say, although many economists say economic globalization already greatly limits the Bank of Mexico's maneuvering room. The advantages, according to proponents, would be felt by every Mexican: a sharp fall in interest and inflation rates. The effectiveness of these actions are still yet to be determined although with a use of a single currency for all of the Americas, Mexico could benefit from that use.
Conclusion.
Complex problems require complex solutions. The research showed that open trade and investment did not cause Mexico's economic problems. Likewise, the country's crisis will not be solved by manipulating trade and current-account balances. In the end, Vasquez (1997) has found that it was not the current-account deficit per se but rather its dubious composition (much of Mexico's borrowing was in the form of short-term government bonds that allowed the government to spend irresponsibly during an election year) that brought about Mexico's crisis. For Mexico the shortcomings of its government's actions can still be changed with every new presidential term. Change comes about as the need develops and there is an apparent need for change in the peso. The people of Mexico are the ones who are directly affected by the value of their money; since changes in the banks and government policy have done little in the ways of fixing the continual destruction, a change in the kind of money used is a viable option.
Works Cited
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Peso Crisis Over in Mexico? Inflation Slowing. (April 2000). World Trade, Volume 13, Issue 4, p. 16.
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Springer, G., L., Molina, J. L. (Summer 1995). The Mexican financial crisis: genesis, impact, and implications , Journal of Interamerican Studies & World Affairs, Volume 37, Issue 1 [EBSCO host].
Thorbecke, Willem; Eigen-Zucchi, Christian. (Fall 2002). Did NAFTA Cause a 'Giant Sucking Sound'? Journal of Labor Research, Volume 23, Issue 4, p. 647.
Vasquez, Ian. (Spring, 1997). The IMF Through a Mexican Lens. Orbis, Volume 41, Issue 2, [EBSCOhost]
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LaFranchi, Howard. (January, 1999). Mexicans Start To Sing, Adios Peso--Hello $$$, Christian Science Monitor. Vol. 91, Issue 32 [EBSCOhost]
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