Economic Condition of Mexico During Pre Crisis Period - Example

Mexico 1994 Crisis: Real Sector Contents Contents 2 Introduction 3 Discussion 3 Economic condition of Mexico during pre crisis period 3 The Crisis 5 Effect on Economic Growth and Gross Domestic Product (GDP) and trade 6 Effect on Inflation, wage and unemployment 8 Effect on Banking System and Central bank monetary policy 10 Conclusion 11 11 Reference List 12 Introduction Nearly about 10 years ago, Mexico faced an economic crisis which is better known as Tequila Crisis or Peso Crisis. The main reason behind the crisis was the Government’s sudden decision of their home currency devaluation (Peso) against US dollar during December, 1994 (Doyran, 2013). his incident gave rise to first international financial crisis which had triggered capital flight around the economy. Hence, the crisis hoarsely affected the financial sector resulting in rising amount of bad debt, fraudulent, collapse of most of the privatized baking sector. It affected the middle class people adversely as well. The middle income group defaulted on repayment of loans as interest rates rose like anything. The GDP decreased to 6.2% (Luong, 2009). Apart from GDP, all the macro economic variables such that unemployment, inflation, wage rates and international trade had experienced negative impact of the sudden currency crisis. In order to understand the detailed impact of the crisis on the country and the economy as a whole, the economic and financial condition before and after the crisis should be evaluated. Discussion Economic condition of Mexico during pre crisis period A decade before the crisis, Mexican economy went through an economic rebalancing in which reforms such that elimination of foreign trade restrictions, initiatives for commercial agreements with other countries, integration with international financial fund flows, legislations for attracting Foreign Direct Investments (FDI), privatization of public enterprises had taken place. Emphasis was given on eliminating unethical trade practices to attract international trade for enhancing competitiveness. Measures had been taken to reduce debt burden to accelerate economic growth in 1989. In 1994, Central Bank of Mexico was made autonomous to stabilize interest rate risk, control inflation and purchasing power of domestic currency (Tucker and Castellanos, 2006). (Coleman, 2005) As a result of taking such corrective measures from 1989 to early 1994, the economy started expecting positive shift in terms of liquidity, favourable interest rates, currency exchange rate and inflow of foreign capital which might lead to further enhancement of consumption and investment (Luong, 2009). However, some of the policies taken during that pre crisis period had left marked implication on the financial crisis on 1994 (Irving, 2010). Measures of reform such that adopting an exchange rate regime to encourage capital inflow in the short run led to current account deficit due to mismanagement of real exchange rate. Initially, interest rates were flexible as the caps on primary auctions were determined by the government itself but as a result of Central bank open market operations, the interest rate became rigid which had left deep impact on secondary market as well (Irving, S. J., 2010). Weak regulations in financial market, inefficient impositions of reform decision, ill structured banking sector hindered large capital inflow into the economy. Asset price touched sky as a result of low level consumption and investment. Domestic saving showed a declining trend. Therefore, in spite of having a projection for sound structural economic reform, faulty internal system and lack of integrity towards implementation of the reform decisions had ignited the financial crisis in upcoming dates. The Crisis The main argument behind the occurrence of the crisis may be reasoned as the decision taken by the newly appointed President of Mexico to devalue the home currency Peso, between 13% and 15%. On 20th December, 1994, the President Mr. Ernesto Zedillo declared a devaluation of currency against their previous promises of not to devalue (Reddy, 2009). The decision made investors sceptical and their further investment became largely dependent on inflow of foreign capital. This leads to generation of risk premia i.e. a difference in expected return on market portfolio and risk free rate of interest of the Central Bank sovereign bonds which further created upward pressure on interest rate. Foreign investors started expecting further devaluation and rapidly started withdrawing capital from the economy. Experiencing this, domestic investors started selling their stock holdings which led to capital flight. In order to control capital flight, Mexican central bank raised interest rates. As a result, further economic growth hindered for higher borrowing costs (Arner, D, 2007). On 22nd of December, government allowance for floatation of Peso resulted in further depreciation of the currency nearly to 50%. In 1995, price level rose to 14% causing for further increment of inflation as much as 52%. The adverse effect of Mexican crisis quickly spread in the financial markets of Asia and America. This crisis is known as Tequila effect in Spain and Brazil (Birdsall, 2006) (Birdsall, 2006) For better understanding of Mexican crisis, effect of it on the macro economic variables should be discussed. Effect on Economic Growth and Gross Domestic Product (GDP) and trade Figure 1. GDP trend before and after the crisis period Gross Domestic Product (GDP) of the economy experienced severe crunches during the crisis period. GDP shrank to 6.2%. in 1995. Current account deficit accounted for 7% of the GDP which had left dangerous impacts on foreign exchange reserve and Balance of Payment (BOP) of the country. Fixed exchange rate slashed against US dollar. As a result of withdrawal of foreign capital, economic growth drastically decelerated, harming the production of the country. Those factors pushed the Mexican economy into another recession. The citizens struggled to cope up with the rising interest rate, still incidents of defaulting mortgage and loans became prominent. The potential growth rate of the country was estimated to be less than 4% as against a growing population of 1.5% contributed towards the reason for a low per capita income. Though the structural reform began the peso crisis, the crisis had staggered the growth of productivity (Doyran, 2013). Figure 2. Fluctuation in international trade before and after the crisis period GDP of an economy is constructed by the contribution of Consumption (C), Investment (I), Government spending (G) and import (I) Export (X) of a country. Hence, Gross Domestic Product can be summarized as, GDP = C + I + G + (X-M). As a result of decreasing foreign investments, expansion of output decreases resulting in decreasing per capita income. This in turn reduced national disposable income as well as the purchasing power of the individuals. As a result, consumption decreases. Amounting level of debt restricted government’s ability to spend more on infrastructural development. Mexico’s financial crisis affected the other economies in a so fierce manner that they also restricted trade with the country, hampering import and export to a large extent (Horowitz and Heo, 2001). However, adjustments took place in the next two quarter, in order to survive the crisis. The country enjoyed the benefit of being the third largest trading partner of America and received North American Free Trade Agreement (NAFTA) to support growth and investments of of the economy. Mr. Bill Clinton, President of America had arranged a standby loan of $ 40 Billion in order to protect the country’s economic and financial interest. This helped the economy to grow at a rate of 5% to 6% for consecutively three years after 1995. Current deficit decreased to 1.4% of the GDP (Irving, 2010). Effect on Inflation, wage and unemployment Figure 3. Inflation trend before and after the crisis period In addition to the Mexican declining GDP, hyperinflation took place as price of economy increased by 35% in 1995. Poverty spread out throughout the country as unemployment closely doubled. Though nominal wages maintained a sustainable position, real wages started falling by 25% to 35% over the same period of time. Unemployment increases to 7.4% in 1995 as compared to the pre crisis unemployment rate of 3.9%. In aggregate, household income declined as much as 30% due to drastic job loss in formal sectors. Hence, average wage rate decreased by 13.5% during the crisis period. As a result, poverty level grew up to 37% during 1995- 1996, destroying the country’s past 10 years’ effort of reducing poverty (McKenzie, 2006). Figure 4. Unemployment trend before and after the crisis period Figure 5. Wage rate trend before and after the crisis period However, in the post crisis period, Mexico has experienced a downward trend of inflation as a positive result of introducing uniformity in monetary and fiscal policies. Declining inflation rate helped the real and nominal interest rates to check their growth potential. This helped the country to encounter debt crisis which boosted further consumption and investment. Corrective measures taken by Mexico to control its inflation stabilized the price level which in turn reduced unemployment by creating job opportunities. Real and nominal wages were controlled thus expanding investment avenues. Such measures helped the nation to consolidate its balance sheet and to shape their economy better (Luong, 2009). Effect on Banking System and Central bank monetary policy The crisis had put great impact on the banking sector of the economy as a whole. The central bank of Mexico controlled the value of Peso through pegging their exchange rate with US dollar (McKenzie, 2006). This enabled the currency to inflate or deflate according to the change in the value of dollar and in order to control such movement the central bank often regulate open market operations and offered buying and selling of Peso to maintain the desired level of pegging. This strategy involved issuing short term debt instruments denominated in US dollar and purchasing Peso from foreign exchange market by using the raised capital. This helped the value of the currency to appreciate with an aim to safeguard the currency against the potential inflationary risk. However, this strategy resulted in weakening the domestic currency. As a result of pseudo strength of Peso as compared to its actual strength the country started experiencing large trade deficit. Policy taken by Mexico’s central bank deviating from the standard policies of any central bank, created anticipation of the crisis among the speculators. Their anticipation proved to be true in 1995 when the investors started experiencing downward market pressure and rising price level. Mexican central bank’s strategy, supported by the current political framework, to purchase its own treasury bills to enhance the monetary base went in vein when such practices of them failed to control the rising interest rate anymore. In such scenario, urgency in dollar repayment to maintain healthy relationship with TESOBONONS resulted in crunches in foreign exchange reserve of the county (McKenzie, 2006). Hence, the central bank had sacrificed their monetary policy autonomy in order to control free flow of financial capital. Central banks foreign exchange reserve continued to decrease due to continuous purchase of US bills up till date of 1995 and their currency continued to deflate as much as 13% to 15%. Noticing such discouraging trend of capital flight, the foreign investors started withdrawing capital from the economy. This also influenced the domestic investors to sell of all their shares and withdraw their invested capital, thrashing the Mexican Stock Exchange and commercial banks to collapse. To discourage such activity, especially in debt market, central bank started raising interest rate. Higher interest rates further raises borrowing costs which highly encumbered the economic growth prospects of Mexico. However, during this crisis period, when the central bank opted for maturing their debt obligations, few investors were found to purchase the issues of public debt. Low foreign reserves on the other hand led the country to stick in the vicious circle of debt due to defaulting in repayment of US debt (Reddy, 2009). Banking system as a whole also experienced severe disaster due to strong rise of inflation and interest rate hike. A large number of debtors failed to pay their loans. Hence, huge amount of nonperforming assets in the commercial bank’s balance sheet drove the banks to go out of business and the government had to depend on bail out programs to control such systematic bank crisis (Sachsa, Tornella, and Velasco, 2000). Conclusion Mexican Currency crisis was a result of a combined effect of poor planning and implementation of norms undertook during the time of economic reform. Financial unrest such that pegging of currency, adverse balance of payment, current account deficit and changing policies in the US as well as political instability ignited the currency crisis to a great extend. Apart from that, sovereign bond crisis gave rise to commercial banking crisis which had caused for further deterioration of the economy. The crisis left a spill over effect upon the global financial economy as well. However, financial support from the U.S. and International Monetary Fund (IMF) and timely access to bail out had helped the economy to survive in the long run. Though the credit to GDP ratio is still low as compared to the international standards, banking and other sectors are trying to shape up heavily relying on the supports from giant economies. (Salgado and Martı́nez, 2004). The central bank has given emphasis to construct and maintain adequate foreign exchange reserve in order support the nation, if such financial and currency crisis occurs in future. In aggregate, restructuring of the policy formulations and reform decisions as well as huge financial support from International Monetary Fund and US government had helped Mexico to survive the crisis and also provided strength to encounter such financial calamity in the future. Reference List Arner, D. W., 2007. Financial Stability, Economic Growth, and the Role of Law. Cambridge: Cambridge University Press. Birdsall, N., 2006. Rising inequality in the new global economy. International Journal of Development Issues, 5(1), pp. 1-9. Coleman, M., 2005. U.S. statecraft and the U.S.–Mexico border as security/economy nexus. Political Geography, 24 (2), pp. 185-209. Doyran, A., 2013. Financial Crisis Management and the Pursuit of Power: American Pre-eminence and the Credit Crunch. Farnham: Ashgate Publishing, Ltd. Horowitz, S. A. and Heo, U., 2001. The Political Economy of International Financial Crisis: Interest Groups, Ideologies, and Institutions. Singapore: Institute of Southeast Asian Studies. Irving, S. J., 2010. Debt Management: Treasury Inflation Protected Securities Should Play a Heightened Role in Addressing Debt Management Challenges. Darby: DIANE Publishing. Luong, J. R., 2009. Debt Management: Treasury¿s Cash Management Challenges and Timing of Payments to Medicare Private Plans. Darby: DIANE Publishing. McKenzie, D. J., 2006. The Consumer Response to the Mexican Peso Crisis. Chicago Journal, 55 (1), pp. 139-172. Reddy, V. Y., 2009. India and the Global Financial Crisis: Managing Money and Finance. London: Anthem Press. Sachsa, J., Tornella, A. and Velasco, A., 2000. The Mexican peso crisis: Sudden death or death foretold? Journal of International Economics, 41(5-6), pp. 265-283. Salgado, J. R. and Martı́nez, A., 2004. Roadmap towards a sustainable hydrogen economy in Mexico. Journal of Power Sources, 129 (2), pp. 255- 263. Tucker, C. and Castellanos, E., 2006. Responding to the coffee crisis: a pilot study of farmers’ adaptations in Mexico, Guatemala and Honduras. The Geographical Journal, 172 (2), pp. 156-171. Read More