“50 Years of Monetary Policy in Mexico”
Prof. JUSTINA HERNANDEZ*PEREZ
In the early 1990s the Mexican economy seemed healthy. It was growing again after the “lost decade” of the 1980s, when the 1982 debt crisis and the 1986 collapse of oil prices sent the economy reeling. Moreover, inflation was being reducedsubstantially, foreign investors were pumping money into the country, and the central bank had accumulated billions of dollars in reserves. Capping the favorable developments was the proposal to reduce trade barriers with Mexico’s largest trade partner, the United States, through the North American Free Trade Agreement (NAFTA). The agreement eventually took effect at the beginning of 1994. Thehard times of the 1980s seemed to be history. Less than twelve months after NAFTA took effect, Mexico faced economic disaster. On December 20, 1994, the Mexican government devalued the peso. The financial crisis that followed cut the peso’s value in half, sent inflation soaring, and set off a severe recession in Mexico.
After reviewing the events leading up to the devaluation, this articleexamines whether Mexican policy mistakes made devaluation inevitable. The discussion then considers Mexico’s policy actions during 1994, along with options Mexico did not take. The final section reviews market response to the devaluation and Mexican and U.S. government efforts to cope with its aftermath.
Was Devaluation Inevitable?
In the aftermath of Mexico’s financial meltdown, did economic policymistakes make devaluation inevitable? A currency is said to be overvalued if its value relative to foreign money is higher than can be justified by long-run economic fundamentals. If a government intervenes in the markets to hold its currency at an overvalued level, in many cases the trade and current accounts go into deficit, thereby shrinking foreign exchange reserves unless offsetting capitalflows in. In some circumstances, devaluation can be an important part of a policy package designed to stop the loss of foreign exchange reserves.
In some cases, an external economic shock causes a country’s exchange rate to become overvalued. For example, in 1986, when the price of oil, Mexico’s main export, plummeted dramatically, the loss of export revenue implied that in the absence of adraconian deflation, peso devaluation was inevitable.
A more common scenario occurs when excessive budget deficits lead to currency overvaluation and, eventually, to devaluation. The deficits, financed at least in part by monetary expansion, generate inflationary pressures. Pegging the exchange rate holds down the domestic rate of inflation temporarily by containing increases in the prices ofimported goods as well as domestic goods that compete heavily with imports. However, the economy runs continuous current account deficits that deplete foreign exchange reserves. At the same time, capital outflows further deplete reserves unless effective capital controls are in place. Eventually, reserves become so small that devaluation becomes virtually inevitable.
Mexico was not followingeither of the above scenarios in the early 1990s. There was no negative external shock comparable in size to the 1986 oil price decline, and Mexico’s fiscal policy appeared to be under control, unlike the situation just before the debt crisis began in 1982. The nonfinancial public sector budget was in surplus in 1992 and 1993 and had small deficits – 0.3 per cent of gross domestic product (GDP) - in1991 and 1994. By contrast, this measure of fiscal policy showed a deficit of 13 percent of GDP during 1981 (Banco de Mexico 1995, 236). An alternative measure of fiscal policy, the primary balance (revenues minus expenditures, excluding interest payments on government debt), was in surplus throughout the early 1990s, though the size of the surplus shrank toward the end of the period. It too had...