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07/09/1999

The Mexican Crisis

In 1982 when the binge of Third World borrowing hit the wall
with the August 1982 Mexican bankruptcy, the U.S. helped out
its neighbor with $1 billion from the Federal Reserve System and
a $1 billion purchase of future oil. Mexico steadied itself with the
help of the James Baker and Nicholas Brady plans for continued
lending and bond write-offs. But in 1994, trouble returned.

In 1994 a number of problems befell Mexico. Peasant revolt, the
assassination of a candidate for president, an earthquake and high
inflation led to a massive capital flight and depreciation of the
peso. First in April 1994, the U.S. and Canada came to the
rescue, largely because of the "special relationship" involved in
the North American Free Trade Agreement (NAFTA) of
November 1993 among the three countries. A credit line of $6.7
billion was put together. But the troubles continued. In
December 1994 another crisis attack on the peso occurred, partly
local capital flight, partly the withdrawal of funds by disenchanted
American investors. This time, in January 1995, the U.S.
orchestrated a rescue of $50 billion, $20 billion from the U.S.
Exchange Stabilization Fund, $17.8 billion from the IMF, $10
billion from European central banks and $2 billion from Canada.
This worked (at least for those attempting to get their funds out).
The hemorraghing stopped, capital returned. Only $12.5 billion
of the American tranche (portion/slice) was drawn and in the fall
of 1995 repayment started. But there is a lot more to the story.

Back in the early 1990s there was talk of a Mexican "miracle."
This was not what some made it out to be. There was a surge in
foreign investment. NAFTA was opening Mexico to American
banks and American bankers. But underneath the runup in
financial markets was an antiquated, disorganized, not modern
economy. Mexico still had a corrupt one-party political system.

Jorge Casteneda is a leading Latin American political scientist and
writer for the New York Times. He also authored a book on the
Mexican crisis. Rather than pretend I am an expert on this,
myself, I thought I would quote him extensively from an interview
he did recently for the PBS "Frontline" program.

"Mexico (began) first opening up to trade, then to capital, and
then privatizing, in order to get the capital to pay for the deficit
coming from the trade opening. Then it begins also having to
carry out a series of other policies in order to keep attracting that
capital. Among those policies are high domestic interest rates and
a stable, virtually frozen, exchange rate so that investors don''t get
scared about devaluations.

Two things happened during the early and mid 1990s. First,
domestic interest rates were so high in order to attract capital that
the economy can''t grow. Because if domestic interest rates paid
out to foreign investors are high, they''re also high as charged to
domestic borrowers. Nobody can borrow. Nobody lends.
Nobody invests. The economy remains relatively stagnant.
Secondly, the exchange rate becomes rapidly overvalued, because
if you can''t play with it, you can''t move it. Your inflation is still
higher than elsewhere. You''re beginning to overvalue in real
terms (overvalue the peso).

This happens between 1990 and 1994. The third element,
NAFTA, which is the instrument designed by the Mexican
government, not by the Americans, to get out of the mess they
had gotten into. That is, a way to attract enough U.S. foreign
investment, direct foreign investment, to be able to finance this
huge current account deficit without high domestic interest rates
and without, at least in the long term, having to prop up the peso
indefinitely. That''s what NAFTA was for from the Mexican
perspective. But all of this, of course, got messed up. It didn''t
work and you have the crash.

[What did the Mexican government face when it promised to
keep the value of the peso as things begin to unravel?].

The general problem that a country like Mexico faced, on several
occasions, the ''70s, ''80s and ''90s, that Brazil has just faced now
late ''98 or early ''99, is that you commit yourself to an exchange
rate in order to guarantee returns on investments in the domestic
currency to foreign investors or to domestic investors, and in
order to guarantee prices, incomes to your domestic economy.

That guarantee is only worth how much money you have in the
bank. And it''s only worth the confidence, the trust, you can
instill in investors and speculators that you will have enough
wherewithal to sustain your currency. If they decide you can''t,
you''ve had it. Because they will end up getting you. Because
they''re acting rationally. They have to speculate against you if
they think that you will not be ble to sustain your currency.

Now, specifically in the case of Mexico in 1993 and 1994, there
was a problem involving NAFTA. There is increasing evidence,
this has not been proven yet.that makes it probable to say that
the Salinas (Mexico''s president) administration made a tacit or
explicit commitment to the Clinton administration in early 1993
that there would be no devaluation of the peso through ''93 and
''94 or at least through mid''94 so that Clinton could get NAFTA
ratified in the U.S. Congress. [Remember the whole debate
between Ross Perot, the AFL/CIO and Gephardt against Clinton
that NAFTA was not in our interest].

So by the middle of 1994 investors, particularly American ones,
started getting nervous and started telling the Mexicans, "Look
we''re leaving." And the Mexicans, "Hey, wait, don''t go away.
You don''t like our pesos? Fine. I''ll transform your investment in
pesos into dollars and I''ll pay you back dollars. I won''t give you
pesos as any exchange rate since you don''t believe me anymore.
You don''t trust me. I''ll give you dollars. Don''t worry about it.
And I''ll pay you 12, 13, 15, 16, 17% per year on your dollar
investment, three to four times what you can get money market
funds in dollars in the U.S." This was a great deal 16% in
dollars? Backed by the Mexican government and turned back by
the Federal Reserve and NAFTA. This is as good a deal as you
get.

So, of course, they stayed in. But the danger was, of course,
Mexico didn''t have the dollars to pay those investors back if they
all wanted their money at some point because reserves were
dwindling. By the end of 1994 there''s only about $6 or $7 billion
left in reserves and short term dollar denominated liabilities are
over $30 billion. Well, it''s pretty simple what happens
collapse."

So we bailed them out. Journalist William Greider described the
whole situation thusly. "These high flyers from Wall Street go
around the world sniffing out hot prospects, make their money.
Then if they''re wrong, if they get burned for any reason, our
government, the Federal Reserve, the IMF feel a responsibility to
help them out of their troubles."

Greider is describing what is now commonly known as "moral
hazard." If there''s a crisis, the IMF or the world community will
come to the rescue. Therefore, you don''t have to ask yourself so
carefully - is this a good investment? - because somebody will
take care of it if it isn''t. **Yes, through Mexico was sown the
seeds of Asia.

Casteneda said, "Investors should not have been flooding East
Asia with money after their experience with Mexico. The
Mexican government borrowed short to invest long. It always
has to keep reborrowing the total amount of this debt.which
every month it has to go back and raise lots of funds just to keep
going. The rescue was very quick, very rapid. The bondholders
were able to get their money out. The consequences were
absorbed in Mexico itself. Once the financial superstructure
collapsed, then, of course, sales went down, production,
employment and so on. Bondholders rescued in hours, people
suffering 4-5 years later.

Greider noted, "We have been reading the celebration for the last
couple of years about Mexico''s great recovery. The reality is, of
course, that Mexico is about where they were two, three, four
years ago, in terms of wages, in terms of employment, etc. The
financial indicators look good again, but the people are
themselves still bleeding. That is predictable, setting off really
turbulent politics in Mexico.

Walk the streets of Mexico City, for instance, and its crime rate is
just out of control. Or you go out in the countryside and the
peasant class that does small-grade agriculture has been
devastated. We ignore these (conditions) at our peril."

The more I read of Latin America, the more I sense a ticking time
bomb that is going to influence our markets in America sooner
than later. This coming Mexican presidential election promises to
be an explosive one. Having it on our borders isn''t very
comforting.

Oh yeah. What did the U.S. stock market do during the crisis?
At the height of the crisis the Dow Jones fell less than 4%
(closing averages) over the course of a few days before quickly
rallying back. On November 15th, 1994 the Dow stood at 3826.
December 30th it closed at 3834. January 30th, 1995 it was 3832.
[The intraday low for the period was set on Nov. 23rd at 3612.]

Next week we will begin to explore the Asian Crisis in more
detail.

[Other source material: Charles P. Kindleberger "Manias, Panics,
and Crashes]

Brian Trumbore



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-07/09/1999-      
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Wall Street History

07/09/1999

The Mexican Crisis

In 1982 when the binge of Third World borrowing hit the wall
with the August 1982 Mexican bankruptcy, the U.S. helped out
its neighbor with $1 billion from the Federal Reserve System and
a $1 billion purchase of future oil. Mexico steadied itself with the
help of the James Baker and Nicholas Brady plans for continued
lending and bond write-offs. But in 1994, trouble returned.

In 1994 a number of problems befell Mexico. Peasant revolt, the
assassination of a candidate for president, an earthquake and high
inflation led to a massive capital flight and depreciation of the
peso. First in April 1994, the U.S. and Canada came to the
rescue, largely because of the "special relationship" involved in
the North American Free Trade Agreement (NAFTA) of
November 1993 among the three countries. A credit line of $6.7
billion was put together. But the troubles continued. In
December 1994 another crisis attack on the peso occurred, partly
local capital flight, partly the withdrawal of funds by disenchanted
American investors. This time, in January 1995, the U.S.
orchestrated a rescue of $50 billion, $20 billion from the U.S.
Exchange Stabilization Fund, $17.8 billion from the IMF, $10
billion from European central banks and $2 billion from Canada.
This worked (at least for those attempting to get their funds out).
The hemorraghing stopped, capital returned. Only $12.5 billion
of the American tranche (portion/slice) was drawn and in the fall
of 1995 repayment started. But there is a lot more to the story.

Back in the early 1990s there was talk of a Mexican "miracle."
This was not what some made it out to be. There was a surge in
foreign investment. NAFTA was opening Mexico to American
banks and American bankers. But underneath the runup in
financial markets was an antiquated, disorganized, not modern
economy. Mexico still had a corrupt one-party political system.

Jorge Casteneda is a leading Latin American political scientist and
writer for the New York Times. He also authored a book on the
Mexican crisis. Rather than pretend I am an expert on this,
myself, I thought I would quote him extensively from an interview
he did recently for the PBS "Frontline" program.

"Mexico (began) first opening up to trade, then to capital, and
then privatizing, in order to get the capital to pay for the deficit
coming from the trade opening. Then it begins also having to
carry out a series of other policies in order to keep attracting that
capital. Among those policies are high domestic interest rates and
a stable, virtually frozen, exchange rate so that investors don''t get
scared about devaluations.

Two things happened during the early and mid 1990s. First,
domestic interest rates were so high in order to attract capital that
the economy can''t grow. Because if domestic interest rates paid
out to foreign investors are high, they''re also high as charged to
domestic borrowers. Nobody can borrow. Nobody lends.
Nobody invests. The economy remains relatively stagnant.
Secondly, the exchange rate becomes rapidly overvalued, because
if you can''t play with it, you can''t move it. Your inflation is still
higher than elsewhere. You''re beginning to overvalue in real
terms (overvalue the peso).

This happens between 1990 and 1994. The third element,
NAFTA, which is the instrument designed by the Mexican
government, not by the Americans, to get out of the mess they
had gotten into. That is, a way to attract enough U.S. foreign
investment, direct foreign investment, to be able to finance this
huge current account deficit without high domestic interest rates
and without, at least in the long term, having to prop up the peso
indefinitely. That''s what NAFTA was for from the Mexican
perspective. But all of this, of course, got messed up. It didn''t
work and you have the crash.

[What did the Mexican government face when it promised to
keep the value of the peso as things begin to unravel?].

The general problem that a country like Mexico faced, on several
occasions, the ''70s, ''80s and ''90s, that Brazil has just faced now
late ''98 or early ''99, is that you commit yourself to an exchange
rate in order to guarantee returns on investments in the domestic
currency to foreign investors or to domestic investors, and in
order to guarantee prices, incomes to your domestic economy.

That guarantee is only worth how much money you have in the
bank. And it''s only worth the confidence, the trust, you can
instill in investors and speculators that you will have enough
wherewithal to sustain your currency. If they decide you can''t,
you''ve had it. Because they will end up getting you. Because
they''re acting rationally. They have to speculate against you if
they think that you will not be ble to sustain your currency.

Now, specifically in the case of Mexico in 1993 and 1994, there
was a problem involving NAFTA. There is increasing evidence,
this has not been proven yet.that makes it probable to say that
the Salinas (Mexico''s president) administration made a tacit or
explicit commitment to the Clinton administration in early 1993
that there would be no devaluation of the peso through ''93 and
''94 or at least through mid''94 so that Clinton could get NAFTA
ratified in the U.S. Congress. [Remember the whole debate
between Ross Perot, the AFL/CIO and Gephardt against Clinton
that NAFTA was not in our interest].

So by the middle of 1994 investors, particularly American ones,
started getting nervous and started telling the Mexicans, "Look
we''re leaving." And the Mexicans, "Hey, wait, don''t go away.
You don''t like our pesos? Fine. I''ll transform your investment in
pesos into dollars and I''ll pay you back dollars. I won''t give you
pesos as any exchange rate since you don''t believe me anymore.
You don''t trust me. I''ll give you dollars. Don''t worry about it.
And I''ll pay you 12, 13, 15, 16, 17% per year on your dollar
investment, three to four times what you can get money market
funds in dollars in the U.S." This was a great deal 16% in
dollars? Backed by the Mexican government and turned back by
the Federal Reserve and NAFTA. This is as good a deal as you
get.

So, of course, they stayed in. But the danger was, of course,
Mexico didn''t have the dollars to pay those investors back if they
all wanted their money at some point because reserves were
dwindling. By the end of 1994 there''s only about $6 or $7 billion
left in reserves and short term dollar denominated liabilities are
over $30 billion. Well, it''s pretty simple what happens
collapse."

So we bailed them out. Journalist William Greider described the
whole situation thusly. "These high flyers from Wall Street go
around the world sniffing out hot prospects, make their money.
Then if they''re wrong, if they get burned for any reason, our
government, the Federal Reserve, the IMF feel a responsibility to
help them out of their troubles."

Greider is describing what is now commonly known as "moral
hazard." If there''s a crisis, the IMF or the world community will
come to the rescue. Therefore, you don''t have to ask yourself so
carefully - is this a good investment? - because somebody will
take care of it if it isn''t. **Yes, through Mexico was sown the
seeds of Asia.

Casteneda said, "Investors should not have been flooding East
Asia with money after their experience with Mexico. The
Mexican government borrowed short to invest long. It always
has to keep reborrowing the total amount of this debt.which
every month it has to go back and raise lots of funds just to keep
going. The rescue was very quick, very rapid. The bondholders
were able to get their money out. The consequences were
absorbed in Mexico itself. Once the financial superstructure
collapsed, then, of course, sales went down, production,
employment and so on. Bondholders rescued in hours, people
suffering 4-5 years later.

Greider noted, "We have been reading the celebration for the last
couple of years about Mexico''s great recovery. The reality is, of
course, that Mexico is about where they were two, three, four
years ago, in terms of wages, in terms of employment, etc. The
financial indicators look good again, but the people are
themselves still bleeding. That is predictable, setting off really
turbulent politics in Mexico.

Walk the streets of Mexico City, for instance, and its crime rate is
just out of control. Or you go out in the countryside and the
peasant class that does small-grade agriculture has been
devastated. We ignore these (conditions) at our peril."

The more I read of Latin America, the more I sense a ticking time
bomb that is going to influence our markets in America sooner
than later. This coming Mexican presidential election promises to
be an explosive one. Having it on our borders isn''t very
comforting.

Oh yeah. What did the U.S. stock market do during the crisis?
At the height of the crisis the Dow Jones fell less than 4%
(closing averages) over the course of a few days before quickly
rallying back. On November 15th, 1994 the Dow stood at 3826.
December 30th it closed at 3834. January 30th, 1995 it was 3832.
[The intraday low for the period was set on Nov. 23rd at 3612.]

Next week we will begin to explore the Asian Crisis in more
detail.

[Other source material: Charles P. Kindleberger "Manias, Panics,
and Crashes]

Brian Trumbore