This essay is engineered at discussing and analyzing the Financial Sector Crisis experienced by Mexico in late 1994, labeled the 'Peso Crisis'. The crisis of international investor confidence in Mexico expanded to several other Latin American countries, notably Argentina. In analyzing this particular event, we will first examine what caused the collapse. We will proceed to look at situations that may have led to this event. The discussion will be formulated into multiple aspects, namely factors surrounding policies in place, the economic and non-economic environment prior to, during and after the crisis.
However, the broader aspect of our discussion will reflect a macro and then a micro economic perspective. When we speak of Macro, we will be specifically referring to Government policies and Macro-economic indicators i. e. Inflation, Exchange rate, Interest rates. From a Micro- perspective, we shall look at the effects on financial institutions, as well as the management practices exercised by some of these institution's leaders. In addition, we will delve into other factors that may have led, whether directly or indirectly, to what some analysts have termed the worst crisis of the 20th century.
We shall open our discussion by first defining what is a financial sector crisis and the importance of a strong economy to the general well being of a country. The financial Sector is an integral part of any country's development and stability (or presumed stability) in this area the financial sector is a very important factor that leads to any form of confidence and most importantly potential investment. Any fears or concerns can lead to a domino effect on the stability and confidence in the sector and the entire economy on a whole.
There may be a reduction in, say, consumer spending which may lead to a reduction potential income thus a reduction in investment and interest. We shall first examine the crisis of Mexico from the Macro Economic perspective, then we shall enter into the micro economic aspects of things. In 1982, the Mexican economy suffered a balance-of-payment crisis, which severely caused panic throughout the country. This was due, as some analysts would have it, to the immense involvement of the public sector in the financial services, as the government had certain control over credit allocation and credit direction.
This scenario was about to be paralleled in 1985 after there were 3 years of stagnant economic activity and stagflation. The government decided that there was a need for change in the economy if it was to prevent its inevitable demise. A number of reforms were then introduced to stimulate some sort of meaningful economic activity. The government had first embarked on an opening up of the trade sector, which was generally to support more external/internal activity. During the mid 1980's to the 1990's, the government also introduced economic reforms geared at stimulating economic growth.
These reforms were apart of three agendas (1) The minimization of the role of the Public sector (2) being the response to the major debt crisis which Mexico had experienced in 1982 (3) Bringing down the rate of inflation. In briefly examining each factor, we shall see that the government wanted to minimize the role the public sector played in offering certain services and thus economic activity was geared at the private sector. What occurred was privatization, certain stringent regulations were eliminated, tax reforms, revision of landownership rights etc.
Another factor that contributed to this goal was the entrance of Mexico into the North American Free Trade Agreement (NAFTA), a policy introduced by the US to facilitate the free movement of goods within a certain trade area or trade bloc. This was somewhat a signal of the intent to the government to open up the markets and shift the reliance of further economic development to the private sector. The government, however, wanted to bring under control the problem of inflation; they wanted to do this while still keeping their economy open.
Whilst this concern is a valid economic one, there was also a political agenda at hand, that year (1994) was an election year and there were popularity concerns at hand. To deal with the inflation problem the government adapted a nominal anchor exchange rate system, a system where the dollar was allowed to float in a specific band and prices of tradable goods were determined by the anchor system, which was kept below the rate of inflation. This would serve as an anchor as this was used to bring down the rate of inflation to a desired level.
This policy did in fact work as the rate of inflation came down gradually over a ten-year period from a high in 1987 of 100% annually to rates of 23% in 1991 to a low of about 9% in 1994. There was much confidence in the economy and Mexico was seen as a role model of a developing country by some experts from the International Monetary Fund (IMF). However there was trouble developing on the horizon as the Mexican economy began to experience a couple of accidents or shocks which came in the form of uprisings, assassinations, bad regulatory frameworks and one I personally coined; 'a misleading shock'.
We shall go in dept later. Social circumstances within the time were far from perfect. As we had mentioned before, 1994 was an election year and there was a period of unrest, there was the Chiapas uprising, which was in response to the commencement of NAFTA. There were the assassinations of (1) Presidential Candidate Donald Colosio (2) An Important Member of the Ruling Political party. These factors had contributed to an almost catastrophic, if not complete, outflow of foreign funds. This can be related to what was said about stability and confidence.
Those occurrences did not do well for these factors and what had happen was there was a reduction in the level of confidence in the economy triggered by the events mentioned above. This resulted in pressure on the country's Net International Reserves (NIR), which would eventually plummet by almost 50%. Additionally and just as important, Mexico's strongest trading partner the United States, had a succession of upward tweaking in its interest rates, which put some strain on the Mexican equivalent.
There was also immediate pressure on the peso, Mexico's domestic currency, which the government could not control and would have had to let go of the managed system that was undertaken. This caused further deterioration of the peso and made a bad situation worse. The 'Misleading Shock', as I like to term it, was the situation where the Mexican economy was not growing as fast as some analyst had thought. Mexico was also suffering from the very thing that was supposed to have helped her. This was the opening up of the trade sector.
The local business sector, especially the manufacturing industry, was suffering from this new openness, as Mexico was not use to this new level of competition. There was a reduction in the demand for goods and services of almost 75% and the fragile manufacturing industry was almost headed for failure, bankruptcies were reported all over Mexico. The liabilities of most of these businesses, due to increased interest rates or loan arrangements, went up 2-3 times their original level, spiraling them into insolvency. At the same time, the portfolios of the banks witnessed a reduction in value in conjunction with the rate of business failure.
When the stagnation period of the 1980's and the increase in the Mexican labor force was taken into consideration. It was seen that the economy did not grow over the period from 1981 to 1988, as some industry experts had stated. There was a minute, almost insignificant, growth over the period of 1987 to 1993 of about 3% . The labor force and the population on a hold grew at a rate that was almost the same or more than economic growth, this shows that the per-capita (GDP/Labor Force) income did not increase but may have decreased slightly even.
This was followed by pressure on the balance of payment cycle, where exports grew less than the rate of increase in imports. This would prove to worsen current account balances. It can be argued that the minimal economic growth, that was experienced was not growth due to increase in real GDP but was actually caused by discrepancies in the accounting practices of Mexican financial institutions. We shall examine this more when looking from a micro perspective. There was also another aim the authorities had during this time, which was the expansion of credit.
The financial sector also experienced some levels of liberalization, which acted as an encouragement to increase the supply of credit; lending and borrowing rates were freed, the forced channeling of credit was abolished, and bank reserve/liquidity requirements were abolished. The government issued short-term instruments called 'Tesobonos'. These instruments will prove later to be a problem. The Mexican authorities had several positive signals that somewhat encouraged the profusion of credit which ranged from improved expectations about the economy presently to where it was projected to go.
There was an improvement in the stock market, availability of debt instruments, favorable debt condition (there was a reduction in the public debt) etc. During the period 1987 - 1993, there was a reduction in public sector credit of 14% of Gross Domestic Product to 2% of GDP. This reduction facilitated a shift in released funds to the Private sector and this was in keeping with Government's desired aim to shift economic activity to the Private sector away from the Public sector. There was the abolition of direct lending, as this proved inefficient for the economy.
Problems would arise, for the banking systems and the financial sector on a whole, out of the massive expansion of debt that occurred. Many years of financial suppression caused a lack of development of very important financial skills such as credit and market risk management. The question I have about the problems is; were these problems caused by crisis? Alternately, were they the cause of the crisis? During the body of this paper, we will see that there was a massive banking sector crisis arising. In order to find out when exactly it occurred we will examine.
The major role of the banking sector in the 1994-1995 crises has been somewhat unacknowledged. This may have been because there were improper accounting practices, as above-mentioned, that may have led to misleading figures, especially in the financial ratios that is, (ROE, ROA, capitalization ratios), that caused the authorities to think, incorrectly, that there was no real cause for concern. What must be stressed is that accounting practices were not the only thing that may have led to the banking crisis.
The banking crisis was almost multi-dimensional. There was the expansion of credit followed by improper management of this newfound freedom of credit extension and then there were the accounting discrepancies that hid the problems ensuing. A mouthful, but we shall get a little bit more in-depth. Let us look at the incorrect practices. The Mexican financial system was nationalized after the crisis of 1982. Interest/exchange rate controls were re-introduced. Certain credit ceilings were adapted.
In 1988, the government issued new financial instruments in the form of banker's acceptance that really were short-term letters issued by companies, which were guaranteed by commercial banks. Overall, deregulation of the banking sector and of financial markets increased capital inflows and gave banks easier access to credit, creating rapid credit expansion. This is where the problem started as banks became increasingly vulnerable because of highly leveraged transactions. There were improper screening practices, credit volume excesses. The lack of prudent risk undertaking was also apparent.
Short-term loans were financed or rolled over into long term loans, however the credit crunch caused a sudden halt to these practices which led to the sharp increase in non-performing loans in the financial sector. There was the occurrence of a lot of short-term borrowing and long term lending done by the financial institutions. The Mexican banking system was unmistakably worsening from 1992 period onwards this was however not a particular concern of the central bank. Bank of Mexico, as it had felt that adequate measures were in place to safeguard the viability of the banking system.
The question that must be asked here is; what was the cause of this substantive boost in credit? We had mentioned before that the government had abolished reserve/liquidity requirement reserves. In addition to this, banks were hastily privatized. Several banks were purchased without their owners proceeding to their proper capitalization i. e. banks were bought using loans which were taken out from those same banks that were being purchased thus no new capital, thus the equity presented was actually liabilities.
The expropriation of the commercial banks in 1982 contributed to their loss of a substantial amount of human capital during the years in which they were under the government. With these, official's institutional memory migrated as well; there was an increase in the risk of moral hazard, extensive risk undertaking excused by implicit/explicit insurance, as there was the situation of unlimited backing of bank liabilities; there were no capitalization rules, based on market risk.
This encouraged asset-liability mismatches, insolvency risk, which in turn led to a liquid liability structure. There was no real supervision of the banking system and this led to an almost overwhelming impact caused by the cataclysmic influx of portfolios of banks. What little regulation that was in place did not have the necessary manpower to go in to institutions to uncover the malpractices of most of these financial institutions. Some bank heads was politically motivated and appointed. There was substantial expansion of credit from the development banks.
As of December 1990, foreigners were obliged to purchase local (short-term) government debt and finally as we had mentioned before there was an issuance of a short-term, peso-denominated financial instrument by the government called a 'tesbonos'. In closer examination of the accounting discrepancies between international standards and Mexican practices we saw that there was a recommended capital ratio of 8% that was somewhat superseded by the Mexican economy under their present practices. However, the Mexican authorities had a definition of what a non-performing loan was, that was somewhat different from international standards.
What was considered a non performing loan in Mexico was the portion of the loan that was not repaid, whilst international standards stipulates that all of the loans even the part that is paid should be considered non performing if there was non payment after a certain stipulated time period usually 90 days by international standards. What this caused was an inflated capital ratio which when the international standards were applied to these conditions it was seen that Mexico fell unacceptably below the recommended standard.