The Mexican Peso Crisis: Exchange, Stabilization, Money, Economy & Falling U.S. Dollar (1995)

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With 1994 being the final year of his administration’s sexenio (the country’s six-year executive term limit), then-President Carlos Salinas de Gortari endorsed Luis Donaldo Colosio as the Institutional Revolutionary Party’s (PRI) presidential candidate for the Mexico’s 1994 general election. In accordance with party tradition during election years, Salinas de Gortari began an unrecorded spending spree. Mexico’s current account deficit had grown to roughly 7% of GDP that same year, and Salinas de Gortari allowed the Secretariat of Finance and Public Credit (Mexico’s treasury) to issue short-term treasury bills denominated in pesos with a guaranteed repayment denominated in U.S. dollars, called tesobonos. These bills offered a lower yield than Mexico’s traditional peso-denominated treasury bills, called cetes, but were more attractive to foreign investors due to the dollar-denominated returns.

Foreign investors’ confidence in Mexico’s economy rose following the signing of the North American Free Trade Agreement (NAFTA) by Canada, Mexico, and the United States. Upon its entry into force on January 1, 1994 Mexican businesses as well as the Mexican government enjoyed access to new foreign capital as outside investors became eager to lend more money. International perceptions of Mexico’s political risk began to shift however, when the Zapatista Army of National Liberation declared war on the Mexican government and began a violent insurrection in Chiapas. Investors further questioned Mexico’s political uncertainties and stability when PRI presidential candidate Luis Donaldo Colosio was assassinated while campaigning in Tijuana in March 1994, and began setting higher risk premia on Mexican financial assets. The higher risk premia initially had no effect on the peso’s value due to Mexico’s fixed exchange rate regime.[4]:375

Mexico’s central bank, Banco de México, maintained the peso’s value through an exchange rate peg to the U.S. dollar, allowing the peso to appreciate or depreciate against the dollar within a narrow band. To accomplish this, the central bank would frequently intervene in the open markets and buy or sell pesos to maintain the peg. The central bank’s intervention strategy partly involved issuing new short-term public debt instruments denominated in U.S. dollars, then using the borrowed dollar capital to purchase pesos in the foreign exchange market, thereby causing its value to appreciate. The bank’s aim in mitigating the peso’s depreciation was to protect against inflationary risks of having a markedly weaker domestic currency. With the peso stronger than it ought to have been, domestic businesses and consumers began purchasing increasingly more imports, and Mexico began running a large trade deficit.[5]:179-180 Speculators in Mexico began recognizing that the peso was artificially overvalued and started investing in U.S. assets in anticipation of its demise. Intending to exchange dollars for pesos later on at an advantageous exchange rate, the capital flows from Mexico to the United States resulting from speculative capital flight actually strengthened downward market pressure on the peso.

Mexico’s central bank deviated from standard central banking policy when supporting a fixed exchange rate. Normally, a country’s central bank would allow its monetary base to decrease and its interest rates to rise. Rather, Mexico purchased treasury bills to support its monetary base in an effort to prevent rising interest rates, motivated by the political pressures of an election year. Additionally, servicing the tesobonos with U.S. dollar repayments further drew down the central bank’s foreign exchange reserves. Consistent with the macroeconomic trilemma in which a country with a fixed exchange rate and free flow of financial capital sacrifices its monetary policy autonomy, the central bank’s interventions to raise the value of the peso by purchasing pesos with dollars against increasing downward market pressure caused Mexico’s money supply to contract (whereas without an exchange rate peg, the currency would have instead been allowed to depreciate). The central bank’s foreign exchange reserves began depleting as a result of its continuous purchases of pesos until it ran out of U.S. dollars completely in December 1994.

http://en.wikipedia.org/wiki/Mexican_peso_crisis

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