1994 Economic Crisis in Mexico - Precursors

Precursors

The crisis is also known in Spanish as el error de diciembre—The December Mistake—a term coined by outgoing president Carlos Salinas de Gortari in reference to his successor Ernesto Zedillo's sudden reversal of the former administration's policy of tight currency controls. While most analysts agree that devaluation was necessary for economic reasons, Salinas supporters argue that the process was mishandled at the political level.

The root causes of the crisis are usually attributed to Salinas de Gortari's policy decisions while in office, which ultimately strained the nation's finances. As in prior election cycles, a pre-election disposition to stimulate the economy, temporarily and unsustainably, led to post-election economic instability. There were concerns about the level and quality of credit extended by banks during the preceding low-interest rate period, as well as the standards for extending credit.

The country's risk premium was affected by an armed rebellion in Chiapas, causing investors to be wary of investing their money in an unstable region. The Mexican government's finances and cash availability were further hampered by two decades of increasing spending, a period of hyperinflation from 1985 to 1993, debt loads, and low oil prices. Its ability to absorb shocks was hampered by its commitments to finance past spending.

Economists Hufbauer and Schott (2005) from the Institute for International Economics have commented on the macroeconomic policy mistakes that precipitated the crisis:

• 1994 was the last year of the sexenio, or six-year administration of Carlos Salinas de Gortari who, following the Partido Revolucionario Institucional (PRI) tradition on an election year, launched a high spending splurge and a high deficit.
• To finance the deficit (7% of GDP current account deficit), Salinas issued the Tesobonos, a type of debt instrument denominated in pesos but indexed to dollars.
• Mexico experienced lax banking or corrupt practices; moreover, some members of the Salinas family collected enormous illicit payoffs.
• The EZLN, an insurgent rebellion, officially declared war on the government on January 1; even though the armed conflict ended two weeks later, the grievances and petitions remained a cause of concern, especially amongst some investors.

Macroeconomics 5th Edition by N. Gregory Mankiw explains the country-risk issues precipitating the crisis:

• The EZLN's violent uprising in Chiapas in 1994 along with the assassination of presidential candidate Luis Donaldo Colosio made the nation's political future look less certain to investors, who then started placing a larger risk premium on Mexican assets.
• Mexico had a fixed exchange rate system that accepted pesos during the reaction of investors to a higher perceived country risk premium and paid out dollars. However, Mexico lacked sufficient foreign reserves to maintain the fixed exchange rate and was running out of dollars at the end of 1994. The peso then had to be allowed to devalue despite the government's previous assurances to the contrary, thereby scaring investors away and further raising its risk profile.
• When the government tried to roll over some of its debt that was coming due, investors were unwilling to buy the debt and default became one of few options.
• A crisis of confidence damaged the banking system, which in turn fed a vicious cycle further affecting investor confidence.