Mauricio Urdaneta Uribe
Tequila Shots: Risk and Negligence during the 1994-95 Mexican Financial Crisis.
Introduction:
Financial liberalization seems like a promising concept for developing economies. Foreign
investors who want better rates than their country has to offer can bring in their capital and
stimulate economic growth. Nevertheless, investment involves risk both for investors and for
investees. Capital controls can limit exuberant growth, but they also limit the risks associated
with it. While Mexico enjoyed their protection during the Bretton Woods Period, it did not
during the final stages of financial liberalization that led to the 94-95 financial crisis. We will
analyze the impact of capital controls or, lack thereof, on risk and return by comparing these two
stages in Mexico’s financial history. 1
Bretton Woods Period:
In the Post War period, countries needed investors' money to rebuild. Since countries' economies
were fragile, investing in them was quite risky. The Bretton Woods System minimized those
risks. The price of gold was kept stable at $35/oz and the rate for other currencies was fixed to
the dollar. This policy assured investors against devaluation risk, impeded speculation, and the
IMF added an additional layer of protection against systemic risk (discussed below focusing on
their effects on the Mexican Economy).
​thesis: ​Composes a detailed, specific and defensible thesis that serves as a central premise to the argument in
question.
1
Mexico Before and during the Bretton Woods Period:
During the Bretton Woods period, Mexico stimulated economic output and cultivated domestic
demand through an import substitution industrialization (ISI) model. Mexico added significant
tariffs and non-tariff barriers on finished products imports while removing controls on capital
goods and kept a fixed exchange rate of $12.5 MXN/ USD (as part of the BW system). While
most of this growth was funded by public investment, Mexico was still open to highly regulated
foreign investment. It was only allowed within government delimited industries, portfolio
investment was prohibited, and any company that operated in the country needed to have
Mexican majority ownership. The fixed exchange rate meant that foreign investments would not
devalue if Mexico suddenly experienced periods of hyperinflation. It also meant that Mexico
could issue dollar denominated debt without significantly higher risk in the nearby future than
peso denominated debt. This model proved highly successful for Mexico. It shortened the trade
deficit, achieved growth substantially higher than the world average (see chart below) and kept
inflation steady at around 3% (Federal Reserve of Dallas, 1995).
Figure 1. Nominal GDP Growth in Mexico and World Average 1960 -1975. Source: World
Bank, n.d.
Due to availability constraints, data begins in 1961. The official end of the Bretton Woods
system came in 1971 when Nixon stopped the fixed convertibility from gold to the dollar and
currency values became floating. During this period, Mexico averaged 3% inflation(discussed
above).
Financial Liberalization in Mexico.
In 1989, president Carlos Salinas de Gortari released his development plan for Mexico. He called
for 6% GDP per capita yearly increase while keeping inflation comparable to its trading partners.
The last 6-year presidential term had seen an average GDP growth of 0.1% per year while
inflation averaged 100% per year. Mexicans experienced a decrease in real disposable income
and high levels of unemployment and underemployment. Fear of further devaluation and
high-risk credit scores following the recent crises made it anti-cost-effective to finance growth
through external capital (Musacchio, 2012). Despite this, Free Trade Agreements signed during
Salinas's term re-opened Mexico to foreign investments, in hopes that they would stimulate
economic growth in the country through liberalizing previously nationalized industries,
privatizing the banking system, removing significant capital controls and incentivizing domestic
borrowing.
Growth during the Salinas period.
Figure 2. Mexico & World Average Nominal GDP Growth, Mexico Inflation (1989-1995).
Source: World Bank, n.d.
While Mexico experienced much more dramatic Nominal GDP growth than the rest of the world,
inflation was even more dramatic, therefore, although there was more money in the country, the
real value of total outputs shrank every year except for 1993. 1995 illustrates the effect of the
crisis to be discussed on GDP and inflation.
In 1989, the Fed started dropping. Investors seeking higher returns searched for investment
opportunities in emerging markets. Mexico portrayed the image of a country on the track to rapid
development. It was suddenly the centre of attention for investors seeking higher returns.
Mexico instituted FOBAPROA, a contingency fund to cover liquidity issues for the newly
privatized banks. While Mexico had partially abandoned the fixed exchange rate regime that
characterized the BW period, it tried to maintain a partial peg with limited mobility to replicate
the reassuring effects that a fixed exchange rate had on investors during the BW period.
Instead of devaluing the currency, Mexico would buy pesos in FOREX markets whenever its
BoP was getting too low, shifting the peso supply curve to the left and raising the value of the
pesos that remained on the market closer to their target “pegged” price. While these two systems
were aimed towards limiting investor risk, they led to moral hazard, as they incentivized risky
behaviours despite the uncertainties that arose from informational asymmetries in the newly
privatized banking system.
Informational asymmetries & government failures.
The Mexican Government delayed the adoption of international accounting standards (Haber,
2004) further complicating accurate risk assessments. Major banks in the country were allowed
to offer loans they could not cover, as they were required to keep a negligible amount of liquid
assets per every peso of debt they offered. Banks were allowed to report the principal of
non-performing loans as performing in their financial statements, therefore, their financial
statements made this banks look significantly "healthier" than they were (Musacchio, 2012).
Inter-bank deposits continued rising, leading to very high leverage ratios, meaning that the
default correlation and the systemic risk associated with interbank lending increased
dramatically. FOBAPROA “explicitly stated that it was not only guaranteeing all deposits
(including inter-bank deposits), it was also guaranteeing virtually all bank liabilities…with the
exception of subordinated debt” (Haber,2005). leading to significant moral hazard.
This process, therefore, increased systemic risk in the Mexican economy to a point where it was
incredibly susceptible to any external shock. And by the end of the Salinas period, many such
shocks occurred.
External Shocks
In 1994 the Fed started rising. Investors' expectations for the returns they could get from
developed economies suddenly made emerging markets, which Mexico was at the forefront of,
significantly less appealing. A military uprising in the south of the country began to place doubts
in investors' minds about stability in Mexico and the risk to their investment that the lack of it
would pose. During the same period, Mexico was going through elections period (typically a
period of high uncertainty in Mexico) and the main candidate was assassinated.2
Mexico tried to increase its own interest rates to attract investors, but the returns they would
obtain did not seem to justify the now apparent risk entailed in keeping their investments in
Mexico, so the first capital outflows began.
Investor Panic
The continuation of the pegged system relied on Mexico's foreign currency reserves, and as the
capital began flowing out of the economy, reserves started draining. Investors did not believe this
peg was sustainable, putting additional downward pressure on the Peso, which further drained
Mexican reserves. Investors started expecting devaluation, feeding the feedback loop between
investor panic of devaluation and pressure to devalue to avoid defaulting.
​#context: ​Situates an argument in its relevant historical context to emphasize the contextual effects of surrounding
circumstances on economic phenomena.
2
In response, Mexico began issuing peso-denominated debt with guaranteed payment in USD.
The dollar-indexed instruments also attempted to replicate the devaluation-risk minimizing
effects that a fixed exchange rate had had during the BW period. However, these instruments
carried with them a significant level of systemic risk. If the country experienced hyperinflation,
the price of these instruments (in pesos) would skyrocket, therefore making it significantly
harder for Mexico to repay these debts. If it was harder for Mexico to repay those debts, it would
face a higher risk of defaulting. If investors noticed that Mexico was at risk of default, they
would try to withdraw their investments, exacerbating the risks of default for Mexico and further
reinforcing the feedback loop that devaluation would trigger in the case of a regime shift in the
system. 3
While portfolio investments were not permitted in Mexico during the BW period, they became
an increasingly larger segment of total foreign investment in Mexico during the Salinas Period.
Portfolio investment is significantly more liquid than FDI. Investors who held this type of
investment, therefore, had a lower threshold for withdrawal, and an easy exit that was buffered
by less liquid FDI, if they decided to exercise the first-movers advantage and withdraw their
investments as soon as devaluation seemed possible.
Stronger capital controls or investment regulations could also have forced investors to keep their
capital invested, ensuring them that other investors would take the same alternative as they
would have faced the same regulations as they did, but since these controls were not present,
#multiplecauses: ​Identifies how multiple causes interact in a complex way to produce a self-reinforcing feedback
loop.
3
considering the high-risk involved, the rational alternative for investors was to stop losses and
withdraw their money.
Considering the devaluating effects that investment withdrawal has on other people's investments
as a negative externality, we could argue that if investors had negotiated these externalities, they
would have been able to arrange a mutually beneficial settlement. Nevertheless, a strong first
movers advantage (discussed above), asymmetric information regarding the level of risk they
faced (discussed above), the lack of an accountability system that would enforce this settlement,
and the high volatility of the period made organization attempts seem impossible in the face of
financial chaos. Transaction costs were too high. No agreement was attempted. Investors
continued withdrawing. Mexico faced no choice but to devalue the peso.
Over $5Bn of investment flowed out of the country in only 2 days. Most banks defaulted, and
their high default correlation (discussed above) meant that FOBAPROA had to bail most of them
out, assuming a total debt that is estimated at 14% of the national GDP by Rojas Suarez, et al.
(1996). Following the bailout, Mexican Banks started raising interest rates even further, which
made borrowing in Mexico almost impossible for local businesses. Since they could no longer
fund the operations they had begun when the MLF had high supply and cheap credit, many of
them defaulted, and thus, the financial crisis spread across the Mexican Economy.
At the same time investment panic associated with emerging markets spread in a phenomenon
popularly dubbed "the Tequila effect"(beyond the scope of this analysis).
References
Banxico. (2009). Exchange Rate Regimes in Mexico since 1954 [Ebook]. Banxico. Retrieved
from
http://www.banxico.org.mx/markets/d/%7B397668FC-BB0B-5F0C-D4A6-241EBE9F0
812%7D.pdf
Gould, D. (1995). Mexico’s Crisis: Looking Back To Assess the Future [Ebook]. Federal
Reserve Bank of Dallas.
Haber, Stephen. 2005. “Mexico’s experiments with bank privatization and liberalization,
1991-2003,” Journal of Banking and Finance 29: 2325–2353.
IMF. (2012). Tequila Hangover: The Mexican Peso Crisis and Its Aftermath [Ebook]. IMF.
Retrieved from https://www.imf.org/external/pubs/ft/history/2012/pdf/c10.pdf
Rojas-Suárez and Weisbrod 1996:11; The Times, July 24th 1998, taken from: Osvaldo Santín
Quiroz, The Political Economy of Mexico’s Financial Reform. Ashgate: Aldershot,
2001. pg 224.
Milestones:
1969–1976
-
Office
of
the
Historian.
(2018).
Retrieved
from
https://history.state.gov/milestones/1969-1976/nixon-shock
Musacchio, A. (2012). Mexico’s financial crisis of 1994-1995 [Ebook]. HBS.
https://dash.harvard.edu/bitstream/handle/1/9056792/12-101.pdf?sequence=1
Easterlin, R. "Why Isn't the Whole World Developed?", Appendix Table 1. The Journal of
Economic History Vol. 41 No. 1, 1981