Question

Investigate the causes of Mexico,s balance of payment difficulties prior to the peso devaluation;

Answer 1

At the time of 1994 crisis, when the economy was facing problem of inflation and stagnation, Mexico made several changes in its economic policies to overcome this problem. They focused on restructuring external debt, private sector oriented growth and encouraging foreign investment. Mexico, in order to encourage it's trade and maintain price stability, pegged it's peso to the US dollar. (Pegged to a currency also known as fixed exchange rate means value of one currency is fixed over value of another currency).

Liberalisation of trade practices was initiated, which led to the increase in both exports and imports, and there was an upward movement in capital inflows due to investment in various portfolios.

Mexico opened it's borders, which increased its economic growth and reduced the inflation, but it thereby made the economy extremely vulnerable to the changes in external affairs.

As the peso was pegged to US dollar, the value of peso was set relatively higher, which increased the purchasing power of the people in Mexico. This in turn led to the increase in imports, majorly from US. This led to the sharp increase in trade deficits. As trade deficits were continuously increasing, they were forced to reduce their domestic savings to pay for the increase in the consumption, so that value of peso could be maintained high.