The Mexican Peso Crisis
This paper argues that the Mexican peso crisis of December 20 should have been expected and foreseeable. In the year preceding the crisis, there were several indicators suggesting that the Mexican economy and peso were already under extreme pressure. The economy bubble was ballooning to burst so much so that it was simply a crisis waiting to happen.
Evidences Signaling the Crisis
1. Decreasing Current Account Deficit versus Increasing Capital Account Balance
Mexico was running an increasing current account deficit from US$7.5 billion in 1990 to US$23.4 billion in 1993. This indicates an excess of private investing over private savings. However, the country was able to maintain an improving fiscal account from US$3.6 billion deficit in 1990 to US$0.7 billion surplus in 1993. The deficit in current account was financed through capital funds from abroad resulting the capital account to increase from US$8.4 billion in 1990 to US$33.8 billion in 1993.
The over-dependent on foreign capital flows had made the Mexican economy very vulnerable to any sudden and major flux of this capital fund which was very much dependent on the investors? confidence level in the Mexican economy.
The fact that majority of the capital funds was in the form of portfolio capital instead of foreign direct investment (FDI) had also worsen the situation. The ratio of portfolio capital to FDI had increased substantially from 1:1.3 in 1990 to 1:6.5 in 1993. Given the volatile nature, portfolio capital tends to respond with greater speed to changes in the environment.
2. Depletion of International Reserve
The central bank of Mexico has built up at high level of international reserve. The huge reserve was the result of the Mexican government?s policy of exchange intervention to prevent large fluctuation in the peso. In the beginning of 1994, the reserve amounted to US$26.4 billion but was depleted to a low US$6.7 billion in Mid Dec, flagging red light that the exchange mechanism had been pushed to the limit and the government can no longer hold on to the pegged peso to US dollar.
3. Increasing Fed Rate but Decreasing Mexican Interest Rate
Federal funds rate has risen the fifth time in 1994 on Nov 1994 and reaches 5.5%. This resulted in stronger dollar against peso as the quantity of US dollar reduced. This signaled problems for Mexico, which was highly dependent on foreign capital funds. There was in fact substantial drop in the flow of foreign equity investment since March 1994 after the assassination of Mr. Colosio.
To counter the impact of federal fund rate increase on peso, Mexican government raised the domestic interest rate by selling more short-term government bonds. The interest rate for peso-denominated cetes rose to 15.79% in April 1994 and increased to 17.07% in July 1994. However, in the second half of 1994, the Mexican government started to reduce the interest rate, contrary to the federal fund rate....