Question

Recently, Mexico experienced large-scale trade deficits, depletion of foreign reserve holdings and a major currency devaluation in December 1994, followed by the decision to freely float the peso. These events also brought about a severe recession and higher unemployment in Mexico. Since the devaluation, however, the trade balance has improved. Investigate the Mexican experiences in detail and provide the following in your answer:

(a) document the trend in Mexico’s key economic indicators, such as the balance of payments, the exchange rate, and foreign reserve holdings, during the period 1994.1 through 1995.12.;

(b) investigate the causes of Mexico’s balance of payments difficulties prior to the peso devaluation;

(c) discuss what policy actions might have prevented or mitigated the balance of payments problem and the subsequent collapse of the peso

(d) derive lessons from the Mexican experience that may be useful for other developing countries.

In your answer, you may identify and address any other relevant issues concerning Mexico’s balance of payment problem. International Financial Statistics published by IMF provides basic macroeconomic data on Mexico.

Answer 1

The economy of Mexico is a developing market economy.Mexico has a strong economy with a gross domestic product that ranks 15th globally . Mexican Economy also ranks 11th interms of purchasing power parity according to the International Economy.

Growth of the economy was not smooth.lt had to go through a several difficulties and some imabalances still persist in the Economy.Peso crisis popularly known as tequila crisis was the most severe economic crisis in the history of Mexico.The crisis can be attributed to overspending.But,as with all crises ,there is far more to it than just living beyond one's means.This story involves rebellion, assassination ,fatricide corruption, friendship , bailout and at last a good ending.

Lets look at the causes of the crisis

*lax Monetary policy pursued in 1994

*Over valued exchange rate of Peso

*Current account deficit increased to 8 percent of the GDP in 1993 and 1994

*Rising debt in the economy of

*Flat or failing reserves

*Erosion of policy credibility and poor regulation.

*Political causes

During the presidential election, government adopted on expansionary fiscal and monetary policy.The Mexican treasury began to issue short term debt instruments denominated in domestic currency with guaranteed repayment in American Euro.When NAFTA was signed, the Economy gained the confidence of investors and access to international capital flows.How ever,there was a tragic incident which pushed the nation into political instability.The presidential candidate Luis Donald Colosio was assassinated.There was also a violent uprising in the state of Chiapas.Funds started to flow outside as Mexico was looked to be in state of heightened political instability. And Ruiz Massieu's untimely death was found to be at the hands of Raul Salinas , the president's brother and Mario Ruiz Massieu, Ruiz Massieus's own brother.

With each damaging blow,tesobono investors were offloading them like they were going out of fashion- and they are.Paying out in dollar further depleted the already low central bank reserves (these hit a reported record of 9 billion dollars)

Atlast devaluation of peso became inevitable.When it finally came on 22 December( peso was devalued by 13-15 percent), the loss of face fell to Zedillo's Government which had only assumed power 23 days earlier.

The impact of the crisis is evident from the following details

*Growth of gross domestic product fell from 4.8 i percent 1994 to -6.2 percent in 1995

*Inflation increased from 7 percent in 1994 to 35.1 percent in 1995

*Rate of unemployment increased from 3.7 percent to 6.2 percent.

*Current account balance had a negative growth of 5.8 percent (-5.8) in 1994 and 0.5 percent (-0 .5) in 1995

As the Mexican Economy continued to collapse there was contagion to other financial markets.These contagion of the Mexican crisis to other emerging markets in1995 is referred to as 'tequilla effect'.

Financial packages were announced by US ,IMF ,BIS and Canada to bail out the Economy from the crisis.US alone gave an aid of 50 billion dollar.Although crisis had a long lead-in time ,it came to a rather quickly and was dispatched with equal haste.

The crisis led to the following realisations.

** lt is important to have multi national safety net to guard the world financial system from these type of crisis

**Mexico excessively depended on the foreign capital to finance it's exonomic development and such a policy had caused more harm to the Economy in the long run.Building self reliance was necessary.

Even though Mexican Peso crisis was not unique there are high chances that it could be repeated in developing or transitional economies.Therefor policy makers must be extra careful and macro economic management must be undertaken With a view of avoiding such a foreign exchange crisis which can prove to be extremely costly for the domestic economy..