Mexico's Financial Crisis: Origins, Awareness, Assistance, and Initial
Efforts to Recover (Chapter Report, 02/23/96, GAO/GGD-96-56).
Pursuant to a congressional request, GAO examined Mexico's financial
crisis, focusing on the: (1) origins of the crisis; (2) extent to which
the U.S. government and the International Monetary Fund (IMF) were aware
of Mexico's financial crisis; (3) U.S. and IMF response to the crisis;
and (4) Treasury's use of the Exchange Stabilization Fund (ESF) to fund
financial assistance to Mexico.
GAO found that: (1) Mexico's financial crisis began in 1994 amid growing
concern over Mexico's fiscal and monetary policies and exchange rate
system; (2) although the United States expressed concern over Mexico's
short-term exchange rate policies, the Federal Reserve and Treasury did
not forsee the magnitude of the crisis; (3) U.S. and IMF assistance to
Mexico was intended to help Mexico overcome its short-term liquidity
crisis and to prevent those effects from spreading to emerging foreign
exchange markets; (4) the United States pledged up to $20 billion in
loans and security guarantees to Mexico under ESF, and IMF pledged $17.8
billion to Mexico under a standby arrangement to be disbursed over 18
months; and (5) the Treasury Secretary acted within his discretion by
using ESF funds to provide assistance to Mexico to promote a stable
exchange rate system.
--------------------------- Indexing Terms -----------------------------
REPORTNUM: GGD-96-56
TITLE: Mexico's Financial Crisis: Origins, Awareness, Assistance,
and Initial Efforts to Recover
DATE: 02/23/96
SUBJECT: International economic relations
Foreign exchange rates
Foreign economic assistance
Economic growth
Foreign currency
Foreign trade agreements
International trade regulation
Investments abroad
Devaluation
Foreign loans
IDENTIFIER: United States
Canada
Mexico
International Monetary Fund
NAFTA
North American Free Trade Agreement
Interagency Country Risk Assessment System
Treasury Exchange Stabilization Fund
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Cover
================================================================ COVER
Report to the Chairman, Committee on Banking and Financial Services
House of Representatives
February 1996
MEXICO'S FINANCIAL CRISIS -
ORIGINS, AWARENESS, ASSISTANCE,
AND INITIAL EFFORTS TO RECOVER
GAO/GGD-96-56
Mexico's Financial Crisis
(280124)
Abbreviations
=============================================================== ABBREV
APEC - Asia-Pacific Economic Cooperation
BIS - Bank for International Settlements
CIA - Central Intelligence Agency
CIEMEX-WESA - Centro de Investigaciones Econometricas de
Mexico-Wharton Econometrics Forecast Associates
ESF - Exchange Stabilization Fund
EZLN - Zapatista Army of National Liberation (Ejercito Zapatista
de Liberacion Nacional)
FOBAPROA - Mexico's deposit insurance agency (Fondo Bancario de
Proteccion al Ahorro)
FOMC - Federal Open Market Committee
FRS - Federal Reserve System
G-10 - Group of 10 industrialized nations
GATT - General Agreement on Tariffs and Trade
GDP - gross domestic product
ICRAS - Interagency Country Risk Assessment System
IFC - International Finance Corporation
IMF - International Monetary Fund
IPC - Mexican Stock Index (Indice de Precios y Cotizaciones)
ITC - International Trade Commission
LIBOR - London Interbank Offered Rate
NAFTA - North American Free Trade Agreement
OECD - Organization for Economic Cooperation and Development
PAN - National Action Party (Partido Acci�n Nacional)
PEMEX - the national petroleum company (Petr�leos Mexicanos)
PRD - Party of the Democratic Revolution (Partido de la
Revolucion Democratica)
PRI - Revolutionary Institutional Party (Partido de la Revolucion
Institucional)
PROCAPTE - Temporary Capitalization Program (Programa de
Capitalizacion Temporal)
SDR - special drawing rights
TELMEX - the national telephone company (Tel�fonos de Mexico)
UDI - Loan Restructuring Program (Unidades de Inversion)
Letter
=============================================================== LETTER
B-261008
February 23, 1996
The Honorable James A. Leach
Chairman, Committee on Banking
and Financial Services
House of Representatives
Dear Mr. Chairman:
This report responds to your request concerning Mexico's financial
crisis. The report examines the origins of Mexico's financial
crisis; assesses the extent to which the U.S. government and the
International Monetary Fund (IMF) were aware of Mexico's financial
problems throughout 1994 and provided advice to Mexico; describes the
U.S. and international response to the crisis, including an
assessment of the terms and conditions of the agreements implementing
the U.S. portion of the assistance; provides an analysis of the
statutory authority for the Secretary of the Treasury's use of the
Exchange Stabilization Fund (ESF) to fund the assistance package; and
examines the initial efforts of Mexico to recover from the crisis,
including Mexico's access to international capital markets.
We are sending copies of this report to interested Members of
Congress, appropriate committees, executive branch agencies, and
Mexican financial officials. Copies will also be made available to
others upon request.
If you have any questions concerning this report, please call JayEtta
Hecker, Associate Director of International Relations and Trade
Issues, at (202) 512-8984. Other major contributors to this report
are listed in appendix IV.
Sincerely yours,
Johnny C. Finch
Assistant Comptroller General
EXECUTIVE SUMMARY
============================================================ Chapter 0
PURPOSE
---------------------------------------------------------- Chapter 0:1
Mexico's devaluation of the peso in December 1994 precipitated a
crisis in Mexico's financial institutions and markets that continued
into 1995. Investor confidence collapsed as investors sold Mexican
equity and debt securities, and foreign currency reserves at the Bank
of Mexico were insufficient to meet the demand of investors seeking
to convert pesos to U.S. dollars. In response to this crisis, the
United States organized a financial assistance package of up to $48.8
billion in funds from the United States, Canada, the International
Monetary Fund (IMF), and the Bank for International Settlements
(BIS). The multilateral assistance package was intended to enable
Mexico to avoid defaulting on its debt obligations, and thereby
overcome its short-term liquidity crisis, and to prevent the crisis
from spreading to other emerging markets.
In light of U.S. commitments to lend Mexico up to $20 billion, the
Chairman of the House Committee on Banking and Financial Services
asked GAO to prepare a comprehensive report on Mexico's 1994-95
financial crisis. In response to this request, GAO (1) examined the
origins of Mexico's financial crisis; (2) assessed the extent to
which the U.S. government and IMF were aware of the severity of
Mexico's financial problems throughout 1994 and provided financial
advice to Mexico; (3) described the U.S. and IMF response to the
crisis, and provided an analysis of the statutory authority of the
Secretary of the Treasury to use the Exchange Stabilization Fund
(ESF) to finance the package and an assessment of the terms and
conditions of the various agreements implementing the U.S. portion
of the assistance;\1 and (4) examined the initial efforts of Mexico
to recover from the crisis, which included a discussion of Mexico's
access to international capital markets. GAO did not address the
issue of whether Mexico would be able to repay the United States for
the assistance.
To achieve its objectives, GAO reviewed documents and spoke with
officials about (1) the risks encountered in international finance;
(2) the history of U.S. and IMF financial assistance for Mexico; (3)
the recent economic and financial reforms in Mexico; (4) the economic
factors leading to Mexico's financial crisis, including monetary
policy, fiscal policy, exchange rate policy, foreign exchange
reserves, debt financing, and current account balance;\2 (5) the
political factors contributing to the loss of investor confidence in
Mexico; (6) the financial health of the Mexican banking system; (7)
the U.S. and IMF assistance package, including statutory authority,
objectives, funding, and terms and conditions; (8) congressional and
other criticisms of the package; (9) implementation of the package;
(10) Mexico's post-crisis economic plan; and (11) the initial effects
of the package on the Mexican economy and Mexico's ability to borrow
on international capital markets.
GAO interviewed officials from (1) the U.S. Department of the
Treasury, Mexico's Secretaria de Hacienda y Credito Publico (Ministry
of Finance), the U.S. Federal Reserve System, and the Bank of
Mexico; (2) the U.S. Department of State and Mexico's Secretaria de
Relaciones Exteriores; (3) IMF; (4) the Mexican Banking and
Securities Commission as well as officials of two
government-sponsored development banks in Mexico; (5) 10 investment
and commercial banks based in the United States, Mexico, and Europe;
(6) 2 U.S. global bond and equity funds with sizable investments in
Mexico; and (7) international and Latin American economic experts at
universities and private research organizations. GAO reviewed U.S.
and Mexican government, international organization, and private firm
documents, including correspondence, memorandums, testimony, cable
traffic, reports, books, regulations, and laws. GAO was provided
copies of and access to large numbers of U.S. government
documents--about
15,000 pages of information--from the U.S. Department of the
Treasury, the Federal Reserve System, and the Department of State.
--------------------
\1 In the past ESF has been used to buy and sell foreign currencies,
extend short-term swaps to foreign countries, and guarantee
obligations of foreign governments. Its use must be consistent with
U.S. obligations in IMF regarding orderly exchange arrangements and
a stable system of exchange rates.
\2 A country's current account measures its transactions with other
countries in goods, services, investment income, and other transfers.
BACKGROUND
---------------------------------------------------------- Chapter 0:2
Historically, the U.S. and Mexican economies have been closely
integrated. In 1994, the United States supplied 69 percent of
Mexico's imports and absorbed about 85 percent of its exports. U.S.
investors have provided a substantial share of foreign investment in
Mexico and have established numerous manufacturing facilities in
Mexico. Also, the United States has served as a large market for
Mexican labor. U.S. economic dependence on Mexico has been less
substantial. Nonetheless, Mexico has been the third largest trading
partner of the United States, accounting for 10 percent of U.S.
exports and about 8 percent of U.S. imports in 1994.
Mexico has experienced several financial crises since 1976 and on a
number of occasions has received U.S. financial assistance to help
it deal with such crises as well as other difficulties. Mexico's
last major financial crisis before 1994 was in 1982, when Mexico was
unable to meet its obligations to service $80 billion in mainly
dollar-denominated debt obligations to U.S. and foreign banks. At
that time, the United States took the lead in developing an
assistance package. The package included short-term currency swaps\3
from the Federal Reserve and ESF, a commitment from Mexico to an IMF
economic austerity program, $4 billion in IMF loans, and a moratorium
on Mexico's principal payments to commercial banks in the United
States and other countries. It also included $5 billion in
additional commercial bank loans, liquidity support from central
banks in Europe and Japan, and prepayment by the United States to
Mexico for $1 billion in Mexican oil.
By the late 1980s, Mexico had largely resolved its debt crisis and
was able to resume economic growth. Mexico continued to rely to a
great extent on foreign investment to finance such growth. To
attract foreign capital, the Mexican government undertook major
structural reforms in the early 1990s designed to make its economy
more open to foreign investment, more efficient, and more
competitive. These reforms included privatizing many state-owned
enterprises, removing trade barriers, removing restrictions on
foreign investment, and reducing inflation and government spending.
In 1994, Mexico entered into the North American Free Trade Agreement
(NAFTA) with the United States and Canada. NAFTA further opened
Mexico to foreign investment and bolstered foreign investor
confidence in Mexico because investors perceived that with NAFTA,
Mexico's long-term prospects for stable economic development were
likely to improve.
Mexico also adopted an exchange rate system intended to help
stabilize the economy. In 1988, the nominal exchange rate\4 of the
peso was fixed temporarily in relation to the U.S. dollar. However,
because the inflation rate in Mexico was greater than that in the
United States, a peso nominal depreciation\5 against the dollar was
needed to keep the real exchange rate\6 of the peso from increasing.
Since the nominal exchange rate of the peso was fixed, the real
exchange rate of the peso appreciated during this period. In 1989,
this fixed exchange rate system was replaced by a "crawling peg"
system, under which the peso/dollar exchange rate was adjusted daily
to allow a slow rate of nominal depreciation of the peso to occur
over time. In 1991, the crawling peg was replaced with a band within
which the peso was allowed to fluctuate. The ceiling of the band was
adjusted daily to permit some appreciation of the dollar
(depreciation of the peso) to occur. The Mexican government used the
exchange rate system as an anchor for economic policy, i.e., as a
means to reduce inflation, encourage a disciplined fiscal policy, and
thus provide a more predictable climate for foreign investors.
Before 1994, Mexico's strategy of adopting sound monetary and fiscal
policies appeared to be having its intended effects. Inflation had
been steadily reduced, government spending was down, and foreign
capital investment was large. Moreover, unlike the years before
1982, most foreign capital was flowing to Mexico's private sector
rather than to the Mexican government to finance budget deficits.
Although Mexico was experiencing a very large current account
deficit,\7 both in absolute terms and in relation to the size of its
economy, this did not appear to present an immediate problem for the
following reasons: Mexico's foreign currency reserves were
plentiful, its exports were growing rapidly, and there did not seem
to be significant risk that Mexico soon would have trouble attracting
and retaining foreign investment. The situation changed in late
1994.
--------------------
\3 Short-term currency swaps are repurchase-type agreements through
which currencies are exchanged. Mexico purchases U.S. dollars in
exchange for Mexican pesos and simultaneously agrees to sell dollars
against pesos 3 months hence. The United States earns interest on
its Mexican pesos at a specified rate.
\4 The nominal exchange rate of a currency is the actual price at
which one currency can be exchanged for another currency at any point
in time.
\5 Depreciation is a decline in the value of one currency relative to
that of another in foreign exchange markets. Devaluation is the
downward adjustment in the official exchange rate of a nation's
currency.
\6 A change in the real exchange rate of a currency takes into
account the impact of both a change in the nominal exchange rate of
that currency as well as the impact of domestic and foreign
inflation. For example, if over the course of a year the inflation
rate in Mexico were 20 percent higher than the inflation rate in the
United States, and the peso price of dollars increased by 20 percent,
the real exchange rate of the peso would not change. However, if the
inflation rate in Mexico were 20 percent higher than that in the
United States and the peso were to depreciate by only 5 percent, the
real exchange value of the peso would increase, or appreciate, by
about 15 percent.
\7 A country can respond to a current account deficit in a number of
ways. These include (1) attracting more foreign capital; (2)
allowing its currency to depreciate, thus making imports more
expensive and exports cheaper; (3) tightening monetary and/or fiscal
policy to reduce the demand for all goods, including imports; and (4)
using foreign exchange reserves to cover the deficit.
RESULTS IN BRIEF
---------------------------------------------------------- Chapter 0:3
According to GAO's analysis, Mexico's financial crisis originated in
the growing inconsistency in 1994 between Mexico's monetary and
fiscal policies and its exchange rate system. Due in part to an
upcoming presidential election, Mexican authorities were reluctant to
take actions in the spring and summer of 1994, such as raising
interest rates or devaluing the peso, that could have reduced this
inconsistency. This fundamental policy inconsistency was exacerbated
by the Mexican government's response to several economic and
political events that created investor concerns about the likelihood
of a currency devaluation. In response to investor concerns, the
government issued large amounts of short-term, dollar-indexed notes
called "tesobonos." By the beginning of December 1994, Mexico had
become particularly vulnerable to a financial market crisis because
its foreign exchange reserves had fallen to $12.5 billion while it
had tesobono obligations of $30 billion maturing in 1995.
Throughout 1994, the U.S. government monitored economic and
political developments that affected the value of Mexico's peso. In
early 1994, U.S. officials had some concerns over the sustainability
of Mexico's exchange rate policies in the short run. They were aware
that Mexico was experiencing a large current account deficit financed
mostly by short-term portfolio capital that was vulnerable to a
sudden reversal of investor confidence in Mexico. However, a number
of other considerations pointed to a more optimistic view of Mexico's
near-term economic prospects. Concerns grew during the year as
pressure on the peso increased, as Mexico's foreign exchange reserves
were drawn down, and as its current account deficit widened. During
March and August, the Federal Reserve and Treasury made two large
swap facilities potentially available to Mexico that would allow
Mexico to improve its ability to cope with short-term pressure on the
peso in international foreign exchange markets.\8 Mexico did not use
these facilities during this period. During October and November,
high-level U.S. officials cautioned Mexican officials that the peso
seemed overvalued and indicated that it was risky to continue the
existing exchange rate policy. U.S. officials, however, were
undecided about the extent to which the peso was overvalued and if
and when financial markets might force Mexico to take action.
Moreover, Federal Reserve and Treasury officials did not foresee the
magnitude of the crisis that eventually unfolded. IMF was less aware
of the seriousness of the situation that was developing in Mexico
during 1994 than was the U.S. government and, for most of 1994, did
not see a compelling case for a change in Mexico's exchange rate
policy.
The objectives of the U.S. and IMF assistance packages, following
the December devaluation and the subsequent loss of confidence in the
peso, were (1) to help Mexico overcome its short-term liquidity
crisis and (2) to limit the adverse effects of Mexico's crisis
spreading to the economies of other emerging market nations and
beyond. Some observers opposed any U.S. financial assistance to
Mexico. They argued that tesobono investors should not have been
shielded from financial losses, and that neither the danger posed by
the spread of Mexico's crisis to other nations nor the risk to U.S.
trade, employment, and immigration were sufficient to justify such
assistance.
The U.S. and international response to Mexico's financial crisis was
one of the largest multilateral economic assistance packages extended
to any one country. The United States pledged up to $20 billion in
loans and securities guarantees from ESF. As part of the amount, the
Federal Reserve agreed to provide up to $6 billion in short-term
swaps from its preexisting swap line. The Treasury Department agreed
to provide backing for the Federal Reserve swaps as part of the ESF
program by assuring repayment of any short-term drawings that were
counted against the $20 billion limit. U.S. assistance was offered
through three mechanisms: (1) short-term currency swaps for up to 90
days, with renewals allowed for a maximum term of 1 year for Treasury
swaps and renewals up to three times for Federal Reserve swaps; (2)
medium-term currency swaps for up to 5 years; and (3) securities
guarantees under which ESF funds could be used to back up securities
issued by Mexico's government for up to 10 years. IMF pledged up to
$17.8 billion in financial assistance in the form of a standby
arrangement for Mexico to be disbursed over a period of 18 months.\9
IMF assistance was designed to bolster gross international reserves
and was conditional upon several things, including Mexico's reducing
its current account deficit and its inflation rate, and strengthening
its fiscal policy.
Mexico has been effectively charged the same interest rate that other
countries pay for short-term currency swaps, a rate tied to the most
recent issue of U.S. Treasury bills, which was 5.25 percent as of
the end of October 1995. For its medium-term swaps, Mexico was
charged interest rates intended to compensate the United States for
the risks of longer-term lending to Mexico--7.55 percent in March,
10.16 percent in April, and 9.2 percent in July 1995. Similarly,
Mexico has been charged standard rates and fees for its IMF
assistance package, drawings under which have a maturity of up to 5
years. Interest rates for IMF drawings have been about 5 percent per
year. In addition, Mexico was charged an annual 0.25 percent
commitment fee for IMF funds remaining available and a 0.50 percent
usage fee on each of its IMF drawings.
As part of the assistance package, the United States and Mexico
entered into an oil agreement to ensure that in the event of a
default by Mexico, the United States would be repaid both principal
and interest from oil export revenues that flow through an account at
the Federal Reserve Bank of New York. Mexico has funds on deposit in
the Federal Reserve Bank of New York generated by the export sales of
Mexican oil. Funds flowing through this account would be used to pay
down Mexico's obligations in the case of a default. More than $6
billion has flowed through this special account from its activation
on March 9, 1995, to November 30, 1995. However, the amount of funds
flowing through the account during any single day would not be
sufficient to cover a major default by Mexico.
Legal opinions from Treasury's General Counsel and the Department of
Justice stated that the Secretary had the requisite authority to use
ESF to provide assistance to Mexico through the three financing
mechanisms previously described. GAO has no basis to disagree.
Under the Gold Reserve Act, as amended, 31 U.S.C. � 5302, the
Treasury Secretary has the authority to commit ESF funds if the
commitment is consistent with IMF obligations of the U.S. government
on orderly exchange arrangements and a stable system of exchange
rates. The act provides the Secretary, with the approval of the
President, the broad discretion to decide when the use of ESF is
consistent with IMF obligations and states specifically that "the
fund is under the exclusive control of the Secretary. . . ." 31
U.S.C. � 5302(2). In accordance with the discretion afforded him
under the act, the Secretary concluded that the assistance package
was consistent with the U.S. obligations to IMF because the Mexican
financial crisis had a destabilizing effect on the peso's exchange
rate and negative repercussions for the overall exchange rate system.
Mexico's economic reforms and the financial assistance package
initially enabled Mexico to satisfy its external debt obligations and
to begin to restructure its short-term debt into longer-term
obligations. Furthermore, as a condition of the assistance, Mexico
was required to adopt a strict economic plan to resolve its economic
problems. While the short-term result has been a severe recession
and economic hardship in Mexico, the plan is intended to lead in the
longer run to sustained economic growth and an economy that will be
attractive to foreign investors. The assistance package and the
implementation of Mexico's economic plan have enabled Mexico to begin
to return to international capital markets. Mexican development
banks were able to borrow again in international capital markets by
the spring of 1995. In addition, the government of Mexico and its
agencies were able to return in the period July through November to
international capital markets to borrow $4 billion. Although the
government of Mexico has taken steps to improve the Mexican banking
system, the banking sector has remained burdened by a nonperforming
loan level estimated by the World Bank at about 27 percent of total
loans as of September 30, 1995.
Despite the progress to date, Mexico still faces many difficult
challenges before its financial crisis can be resolved. Interest
rates continue to be high, the peso continues to be volatile, the
banking sector remains strained, and economic growth is weaker than
predicted. Thus, it remains to be seen whether Mexico will be able
to maintain economic policies that will allow the economy to recover
from the crisis.
--------------------
\8 The August facilities were provided on a contingency basis in
cooperation with other countries.
\9 A standby arrangement is a commitment by IMF to provide funds that
is conditional on the country's performance--particularly with
respect to targets for economic policies (performance criteria)
specified in a letter of intent.
PRINCIPAL FINDINGS
---------------------------------------------------------- Chapter 0:4
ORIGINS OF THE FINANCIAL
CRISIS
-------------------------------------------------------- Chapter 0:4.1
The evidence GAO reviewed showed that the origins of Mexico's
financial crisis can be found in the interplay of a number of complex
financial, economic, and political factors during 1994. In
combination, these factors made Mexico's monetary and fiscal policies
inconsistent with its exchange rate policy. At the beginning of the
year, Mexico was experiencing a boom in foreign investment. The boom
was related in part to investors' perceptions that Mexico's economy
was fundamentally strong. The investment surge was also bolstered by
approval of NAFTA. However, a substantial part of the financial
inflow was in the form of equity and debt portfolio investments\10
that could be withdrawn quickly.
The first significant drop in investor confidence in Mexico in 1994
and the related drop in Mexican foreign currency reserves occurred
following the assassination of Mexican presidential candidate Luis
Donaldo Colosio on March 23. On March 24, U.S. authorities agreed
to make available a temporary short-term credit facility of $6
billion. Mexico's foreign currency reserves fell $7.1 billion, from
$24.4 billion at the end of March to $17.3 billion at the end of
April. Mexican authorities attributed the decline in investor
confidence primarily to the shock of the assassination and took
several actions to stem the outflow of foreign exchange reserves.
The peso was allowed to depreciate less than 1 percent against the
dollar to the limit imposed by the exchange rate band. This followed
a 7-percent depreciation that had taken place in the month preceding
the assassination. In April 1994, in connection with the
establishment of the North American Financial Group, a consultative
body consisting of finance ministries and central banks of the United
States, Canada, and Mexico, these three partners established a
trilateral agreement to make available a short-term credit facility
of $6 billion from the United States and one billion Canadian
dollars. Also, the Bank of Mexico increased domestic interest rates
from 9 percent to 18 percent on short-term, peso- denominated Mexican
government notes called "cetes" in an attempt to stem the outflow of
capital.
However, in spite of higher interest rates, investor demand for cetes
continued to lag. Investors were demanding higher interest rates on
newly issued cetes because of their perception that the peso would
eventually be subject to a relatively large devaluation. Options
available to the Mexican government at this time included (1)
offering even higher interest rates on cetes; (2) reducing government
expenditures to reduce domestic demand, decrease imports, and relieve
pressure on the peso; or (3) devaluing the peso. From the
perspective of Mexican authorities, the first two choices were
unattractive in a presidential election year because they could have
led to a significant downturn in economic activity and could have
further weakened Mexico's banking system. The third choice,
devaluation, was also unattractive, since Mexico's success in
attracting substantial foreign investment depended on its commitment
to maintain a stable exchange rate. In addition, a stable exchange
rate had been an essential ingredient of long- standing policy
agreements between government, labor, and business, and these
agreements were perceived as ensuring economic and social stability.
Also, the stable exchange rate was a key to continued reductions in
the inflation rate.
Rather than adopt any of these options, the government chose, in the
spring of 1994, to increase its issuance of tesobonos. Because
tesobonos were dollar-indexed, holders could avoid losses that would
otherwise result if Mexico subsequently chose to devalue its
currency. The Mexican government promised to repay investors an
amount, in pesos, sufficient to protect the dollar value of their
investment. Tesobono financing effectively transferred foreign
exchange risk from investors to the Mexican government.\11 Tesobonos
proved attractive to domestic and foreign investors. However, as
sales of tesobonos rose, Mexico became vulnerable to a financial
market crisis because many tesobono purchasers were portfolio
investors who were very sensitive to changes in interest rates and
risks. Furthermore, tesobonos had short maturities, which meant that
their holders might not roll them over if investors perceived (1) an
increased risk of a Mexican government default or (2) higher returns
elsewhere. Nevertheless, Mexican authorities viewed tesobono
financing as the best way to stabilize foreign exchange reserves over
the short term and to avoid the immediate costs implicit in the other
alternatives. In fact, Mexico's foreign exchange reserves did
stabilize at a level of about $17 billion from the end of April
through August, when the presidential elections came to a conclusion.
Mexican authorities said they expected that investor confidence would
be restored following the August presidential election and that
investment flows would return in sufficient amounts to preclude any
need for continued, large-scale tesobono financing.
Following the election, however, foreign investment flows did not
recover to the extent expected by Mexican authorities in part because
peso interest rates were allowed to decline in August and were
maintained at that level until December. During the fall of 1994, it
became increasingly clear to some Mexican government officials that
Mexico's mix of monetary, fiscal, and exchange rate policies needed
to be adjusted. The current account deficit had worsened during the
year, partly as a result of the strengthening of the economy related
to a moderate loosening of fiscal policy, including a step up in
development lending. Imports had also surged as the peso became
increasingly overvalued. Mexico had become heavily exposed to a run
on its foreign exchange reserves as a result of substantial tesobono
financing. Outstanding tesobono obligations increased from $3.1
billion at the end of March to $29.2 billion in December. Also,
between January 1994 and November 1994, U.S. 3-month Treasury bill
yields had risen from 3.04 percent to 5.45 percent, substantially
increasing the attractiveness of U.S. government securities.
In the middle of November 1994, Mexican authorities had to draw down
foreign currency reserves in order to meet the demand for dollars.
On November 15, in response to U.S. economic conditions, the U.S.
Federal Reserve raised the federal funds rate by three- quarters of a
percentage point, raising the general level of U.S. interest rates
and further increasing the attractiveness of U.S. bonds to
investors. Then in late November and early December, renewed
fighting in the Mexican state of Chiapas and an unfolding scandal
surrounding the September 1994 assassination of Institutional
Revolutionary Party Secretary General Francisco Ruiz Massieu renewed
apprehension among investors regarding Mexico's political stability.
These concerns were compounded on December 9, when the new Mexican
administration revealed that it expected an even higher current
account deficit in 1995 but planned no change in its exchange rate
policy. This decision led to a further loss in confidence by
investors, increased redemptions of Mexican securities, and a
significant drop in foreign exchange reserves, to $10 billion.
Meanwhile, Mexico's outstanding tesobono obligations reached $30
billion, with all coming due in 1995. However, Mexican government
officials continued to assure investors that the peso would not be
devalued.
On December 20, Mexican authorities sought to relieve pressure on the
exchange rate by announcing a widening of the peso/dollar exchange
rate band. The widening of the band effectively devalued the peso by
about 15 percent. However, the government did not announce any new
fiscal or monetary measures to accompany the devaluation--such as
raising interest rates. This inaction was accompanied by more than
$4 billion in losses in foreign reserves on December 21, and on
December 22, Mexico was forced to freely float its currency. The
discrepancy between the stated exchange rate policy of the Mexican
government throughout most of 1994 and its devaluation of the peso on
December 20, along with a failure to announce appropriate
accompanying economic policy measures, contributed to a significant
loss of investor confidence in the newly elected government and
growing fear that default was imminent. Consequently, downward
pressure on the peso continued. By early January 1995, investors
realized that tesobono redemptions could soon exhaust Mexico's
reserves and, in the absence of external assistance, that Mexico
might default on its dollar-indexed and dollar-denominated debt.
--------------------
\10 Portfolio investments are assets held in the form of marketable
equity and debt securities. Portfolio investment--in contrast to
direct investment--tends to be more liquid in nature and more likely
to be short term. This is not to suggest, however, that selling
pressures on a currency are more likely to arise or be more severe in
the presence of substantial foreign portfolio investment.
Historically, there have been market-forced devaluations when
portfolio investment has been almost nonexistent.
\11 Foreign exchange risk is the risk of unexpected adverse movements
in exchange rates, causing a loss of value of assets or income
denominated in the foreign currency.
U.S. AND IMF ADVICE TO
MEXICO
-------------------------------------------------------- Chapter 0:4.2
As 1994 began, U.S. officials were somewhat concerned that Mexico
was vulnerable to speculative attacks on the peso and that Mexico's
large current account deficit and its exchange rate policy might not
be sustainable. However, these concerns largely were outweighed by
other considerations. For example, U.S. officials generally thought
that Mexico's economy was characterized by sound economic
fundamentals and that, with the major economic reforms of the past
decade, Mexico had laid an adequate foundation for economic growth in
the long term. Further, Mexico was attracting large capital inflows
and had substantial foreign exchange reserves. Concerns about the
viability of Mexico's exchange rate system increased following the
assassination of Mexico's presidential candidate Luis Donaldo Colosio
in the latter part of March and the subsequent drawdown of about $10
billion in Mexican foreign exchange reserves by the end of April.
Just after the assassination, Treasury and Federal Reserve officials
temporarily enlarged longstanding currency swap facilities with
Mexico from $1 billion to $6 billion. These enlarged facilities were
made permanent with the establishment of the North American Financial
Group in April. The initiative to enlarge the swap facilities
permanently preceded the Colosio assassination. Mexican foreign
exchange reserves stabilized at about $17 billion by the end of
April.
At the end of June 1994, a new run on the peso was under way.
Between June 21 and July 22, foreign exchange reserves were drawn
down by nearly $3 billion, to about $14 billion. In early July,
Mexico asked the Federal Reserve and Treasury to explore with the
central banks of certain European countries the establishment of a
contingency, short-term swap facility. That facility could be used
in conjunction with the U.S.-Mexican swap facility to help Mexico
cope with possible exchange rate volatility in the period leading up
to the August election. By July, staff in the Federal Reserve had
concluded that Mexico's exchange rate probably was overvalued and
that some sort of adjustment eventually would be needed. However,
U.S. officials thought that Mexican officials might be correct in
thinking that foreign capital inflows could resume following the
August elections. In August, the United States and BIS established
the requested swap facility, but not until U.S. officials had
secured an oral understanding with Mexico that it would adjust its
exchange rate system if pressure on the peso continued after the
election. The temporary facility incorporated the U.S.-Mexican
$6-billion swap arrangement established in April. At the end of
July, pressure on the peso abated, and Mexican foreign exchange
reserves increased to more than $16 billion. Significant new
pressure on the peso did not develop immediately following the August
election, but at the same time, capital inflows did not return to
their former levels.
According to the documents GAO reviewed, between August and December
20, 1994, U.S. government analyses generally concluded that the peso
was overvalued. However, analysts were not sure to what extent the
peso was overvalued and whether and when financial markets might
force Mexico to devalue the peso. Estimates of the overvaluation
ranged between 5 and 20 percent. As the year progressed, U.S.
officials thought it increasingly likely that Mexico would have to
devalue in the near future. However, as late as mid-December, U.S.
government analysts and senior officials believed that Mexico might
make it into early 1995 without having to devalue.
In spite of these uncertainties, during October and November 1994,
U.S. officials advised Mexican officials on several occasions that
they thought that their exchange rate policy was risky and indicated
that they believed some sort of policy response was in order.
However, as a senior Treasury official has testified, the U.S.
ability to influence Mexico's economic policy decisions was limited
because Mexico is a sovereign country. In addition, it is not
apparent from the evidence GAO reviewed that, at any time in 1994,
U.S. officials believed they could argue with certainty that the
peso was overvalued and that Mexico should devalue. U.S. officials
were aware that investors in Mexican government securities perceived
relatively small risks of a Mexican devaluation or default on its
debts as measured by interest rates demanded on Mexican securities
relative to interest rates for U.S. government securities.
Furthermore, based on records that GAO reviewed and interviews with
U.S. officials, the Federal Reserve and Treasury did not foresee the
serious consequences that an abrupt devaluation would have on
investor confidence in Mexico. These included a possible wholesale
flight of capital that could bring Mexico to the point of default
and, in the judgment of U.S. and IMF officials, require a major
financial assistance package. One reason Treasury and Federal
Reserve officials did not publicly reveal their concerns over
Mexico's exchange rate system was that they were concerned that they
might have provoked an immediate flight of foreign investment from
Mexico.
IMF did not conclude that there was a major problem with Mexico's
exchange rate situation during 1994. Although Mexico was repaying
IMF loans, Mexico was not receiving new IMF financial assistance in
1994. This limited the amount of economic information that IMF was
receiving on Mexico. In an annual country review completed in
February 1994, IMF stressed the need for Mexico to lower its current
account deficit. However, according to a Treasury official, IMF
officials thought that Mexico's sizable exports meant there was not a
need to adjust the foreign exchange policy. According to IMF and
Treasury officials that GAO interviewed, IMF, like many informed
observers, did not foresee the exchange rate crisis and, for most of
1994, did not see a compelling case for a change in Mexico's exchange
rate policy.
U.S. AND IMF RESPONSE TO
THE CRISIS
-------------------------------------------------------- Chapter 0:4.3
Although Treasury, the Federal Reserve, and IMF did not anticipate
the magnitude of the peso crisis that unfolded in late December 1994,
they soon concluded that outside assistance was required to prevent
Mexico's financial collapse. Further, Treasury and Federal Reserve
officials testified that the crisis threatened to spread to other
emerging market countries. They also believed the Mexican crisis
could undermine market-oriented economic reforms that the United
States and IMF have urged those countries to adopt. In addition,
Treasury and Federal Reserve officials were concerned that Mexico's
financial crisis could escalate into a prolonged and severe economic
downturn in Mexico that would put important U.S. interests at
risk--including trade, employment, and immigration.
Some observers argued that the United States should not have provided
financial assistance to Mexico at all. They said that it was
inappropriate for the U.S. government to place taxpayer funds at
risk to prevent tesobono investors from incurring financial
losses--even if not lending assistance meant Mexico would default on
its short-term debts. In fact, they contended that supplying
financial assistance to Mexico to pay off tesobono obligations could
make future Mexico-like crises more likely, because it would create a
"moral hazard" problem, i.e., it would encourage future investors in
emerging markets to make riskier investments than they otherwise
would have made because they would expect to receive U.S. government
assistance during another crisis. Also, critics of U.S. financial
assistance contended that the effect of Mexico's crisis on other
nations was either a temporary market overcorrection that would have
reversed itself before seriously harming U.S. investors or other
emerging markets or that it was an appropriate market correction
because investors had overinvested in these markets in the first
place. Lastly, some people argued that the threat a Mexican
government default posed to U.S. trade, employment, and immigration
was not sufficient to warrant U.S. financial assistance to Mexico.
At the beginning of January 1995, Mexico activated and drew down its
$6-billion short-term swap facility with the Federal Reserve and
Treasury and its swap facility with the Bank of Canada. On January
12, 1995, the President announced a U.S. assistance package for
Mexico consisting of loan guarantees of up to $40 billion.
Implementation of this initial assistance package required
congressional approval. Although the bipartisan leadership of both
houses of Congress endorsed the package, it ran into substantial
congressional opposition.
Subsequently, on January 31, 1995, President Clinton announced a
$48.8-billion multilateral assistance package. Under this package,
the United States would provide up to $20 billion to Mexico through
the use of ESF and the Federal Reserve swap network. The package was
a combination of short-term swaps with renewals allowed, medium-term
swaps of up to 5 years, and securities guarantees with terms of up to
10 years. These swaps and securities guarantees were conditioned on
strict economic, financial, and reporting requirements. On February
1, 1995, IMF approved an 18-month standby arrangement for Mexico for
up to $17.8 billion. This arrangement, also conditioned upon
Mexico's adherence to strict economic performance targets, was the
largest financing package ever approved by IMF for a member country,
both in terms of the amount and the overall percentage of a member's
credit quota--in Mexico's case, 688.4 percent over 18 months (the
usual cumulative limit is 300 percent). The primary purpose of the
U.S., IMF, and other assistance was to allow Mexico to overcome its
short-term liquidity crisis and thereby prevent Mexico's financial
collapse.\12
The government of Mexico has drawn on the international assistance
offered by both the United States and IMF. As of December 22, 1995,
$13.5 billion in U.S. funds had been disbursed to Mexico under the
support program. Of this amount, $11.8 billion remained outstanding:
$1.3 billion in short-term swaps and $10.5 billion in medium-term
swaps. As of December 31, the United States had not extended any
securities guarantees to Mexico. Through the end of 1995, Mexico had
not missed any interest payments or required principal repayments
under any of the swaps. As of December 31, ESF had received $447.4
million in interest payments from Mexico for short- and medium-term
swaps, and the Federal Reserve had received $46 million in interest
on its short-term swaps with Mexico. On January 2, 1996, $242.4
million in interest was due to Treasury on the medium-term swaps; a
Treasury official confirmed that that interest payment has been
received. In early October 1995, Mexico prepaid $700 million of the
$2 billion in swaps coming due October 30 anticipating the proceeds
from a German mark- denominated bond issue. Mexico had also drawn
$13 billion from IMF by the end of December, none of which had fallen
due or been repaid.
In connection with the implementation of the financial assistance
package, the Secretary of the Treasury received two legal opinions
that addressed his authority to use ESF. The Treasury General
Counsel and the Department of Justice opinions both concluded that
the Secretary had the requisite authority to use ESF to provide
assistance to Mexico as contained in the support package. GAO has no
basis to disagree with this conclusion.
Under the Gold Reserve Act of 1934, as amended, 31 U.S.C. � 5302,
the Secretary of the Treasury has the authority to commit ESF funds
if the commitment is consistent with IMF obligations of the U.S.
government on orderly exchange arrangements and a stable system of
exchange rates. The act gives the Secretary, with the approval of
the President, the broad discretion to decide when the use of ESF is
consistent with the IMF obligations of the United States and states
specifically that "the fund is under the exclusive control of the
Secretary. . . ." 31 U.S.C. � 5302(a)(2). In the case of Mexico,
the Treasury Secretary determined that the assistance package was
consistent with U.S. obligations to IMF on assuring orderly exchange
arrangements and promoting a stable system of exchange rates.
Particularly, in this regard, IMF members agree to "seek to promote
stability by fostering orderly underlying economic and financial
conditions and a monetary system that does not tend to produce
erratic disruptions."\13 In accordance with the discretion afforded
him under the statute, the Secretary decided that the assistance
package was consistent with these purposes because the Mexican
financial crisis had had a destabilizing effect on the peso's
exchange rate and negative repercussions for the overall exchange
rate system. In addition, IMF announced its own assistance package
that served the same primary objective as did the U.S. assistance
package.
To put the U.S. assistance package into place, the United States and
Mexico entered into four financial agreements that provide Mexico
with up to $20 billion--the framework agreement, the oil agreement,
the Medium-Term Exchange Stabilization Agreement (medium-term
agreement), and the Guarantee Agreement, which are collectively
referred to as "the agreements." The agreements provide that Mexico
may utilize up to $20 billion of ESF resources in the form of
short-term swaps, medium-term swaps, and securities guarantees. In
order to have access to this funding, and during the period that any
loans are outstanding, Mexico must satisfy certain economic,
monetary, and fiscal conditions, as well as meet certain reporting
requirements.
The short-term swap transactions may be provided in an aggregate
amount of up to $9 billion,\14 through either the resources of the
Federal Reserve or ESF, with maturities of up to 90 days. The
Treasury and Mexico may enter into medium-term swap transactions with
maturities of up to 5 years up to an amount that, when added to the
amount of outstanding short-term swaps and guarantees, does not
exceed $20 billion. In connection with any medium-term swap
transaction, Mexico is required to maintain the dollar value of peso
credits to the United States, adjusting the amount of pesos on a
quarterly basis, to reflect changes in the peso-dollar exchange rate.
Finally, ESF funds may be used to guarantee the payment of all or
part of the principal of and interest on debt securities denominated
in U.S. dollars to be issued by the government of Mexico. No
guarantee may be issued with respect to principal or interest
payments due more than 10 years after the date of issuance of the
debt securities. The swaps and guarantees may be disbursed for a
period of 1 year, with an optional 6-month extension, after the
effective date of the framework agreement--February 21, 1995.
The interest rates applied to the short-term swaps are intended to
cover the cost of funds to Treasury and therefore are to be set at
the inception of each swap transaction based on the then-current
91-day U.S. Treasury bill interest rate. This is the same rate that
the Federal Reserve and Treasury charge other countries for
short-term currency swaps. As of August 1, 1995, the annual rate for
short-term swaps was 5.45 percent.
Mexico is to be charged a higher interest rate for medium-term
assistance that will be at least sufficient to meet the current U.S.
government credit risk rating for Mexico. Interest charges, which
are to be determined at the time of disbursement on the medium-term
swaps, are to be designed to cover the costs of funds to Treasury
plus a premium for the risk associated with the extension of funds.
For each medium-term swap disbursement, the premium is to be the
greater of (1) a rate determined by the U.S. government's
Interagency Country Risk Assessment System (ICRAS) to be adequate
compensation for sovereign risk\15 of countries such as Mexico or (2)
a rate based on the amount of U.S. funds outstanding to Mexico from
short- and medium-term swaps and securities guarantees at the time of
disbursement. The rates for medium-term swaps were 7.8 percent for
funds disbursed in March, 10.16 percent for funds disbursed in April
and May, and 9.2 percent for funds disbursed in July.
Under the guarantee agreement, Mexico is to pay to the Treasury
Department a guarantee fee calculated using a present value formula.
The variables in the formula include the amount to be guaranteed, the
maturity of the debt securities, Treasury's borrowing rate for the
same maturity, Mexico's cost of borrowing with the guarantee, and an
appropriate credit risk premium, which is to be the greater of the
ICRAS premium, or 225 to 375 basis points, depending on the total
amounts outstanding. As an example, if the United States were to
guarantee $8 billion of debt securities issued by the government of
Mexico, the agreement provides for Mexico to pay the Treasury
Department a guarantee fee of about $1.9 billion.\16
In circumstances such as the Mexican financial crisis, in which
financial markets essentially ceased to function in terms of Mexico's
access,\17 markets cannot be relied on to provide a measure of the
risk. GAO believes that the use of the ICRAS rate as a starting
point, followed by adjustments, was a reasonable approach to
establish the risk premiums.
The Treasury and Mexico entered into the oil agreement to help ensure
that if Mexico defaults on its obligations, the United States will be
repaid from oil export proceeds earned by Mexico's state-owned oil
company, Petr�leos Mexicanos (PEMEX). In Treasury's view, the oil
proceeds payment mechanism, while not providing an absolute assurance
of repayment, does provide the United States with a high degree of
repayment assurance. According to Treasury officials, the current
oil facility's reliability has been improved compared to oil
facilities used in the past.
Under the oil agreement, proceeds from PEMEX's sales of oil to export
customers are to be deposited into a special account at the Federal
Reserve Bank in New York. Export customers have to acknowledge
irrevocable payment instructions from PEMEX, and for the benefit of
the United States, to deposit payments into PEMEX's account at a
major international bank in New York. PEMEX has also irrevocably
instructed this major international bank to transfer these payments
into a special account of the Bank of Mexico at the Federal Reserve
Bank of New York. The United States has a right of set-off\18
against funds in the account if Mexico defaults on the assistance
package.
The oil agreement does not require a minimum balance and, absent a
default, proceeds should regularly flow out of the account to the
Bank of Mexico. Since the initiation of the facility, Treasury
records show that in any one day, an average of $25 million to $30
million has flowed into and out of the account. About $6.8 billion
flowed through the account during 1995. Under the terms of the
agreement, there are no controls over the funds in the account if
Mexico is current on all its obligations to Treasury, and money need
not accumulate in the account even until the end of the day; at most,
a single day of proceeds may be in the account.
Treasury officials maintain that the mechanism depends on the flow of
funds following any default. They point out that the coverage
provided by this flow is greater than outstanding obligations of
Mexico to the United States. A threshold mechanism allows Treasury
to require prepayment if export volumes or oil prices decline 15 to
25 percent from 1994 levels. Changes in future flows may affect the
time needed for obligations to be repaid and Treasury would be
compensated through late charges.
Consequently, a single day's flow would not be sufficient to cover a
major default by Mexico. Once a default has occurred, the Federal
Reserve Bank of New York has been authorized to use the funds in the
special account to repay all amounts due and payable under the
assistance agreements. The account could be used over time to cure a
default provided that PEMEX continued to produce and export oil to
the customers covered by the oil agreement. Changes in the world
price of crude oil and petroleum products could affect the amounts of
the deposits made and thus the time that would be needed to pay off
any default. Because of these uncertainties, in GAO's view, the oil
agreement by itself cannot be considered as providing a high degree
of assurance that the United States will be repaid if Mexico defaults
on its loans or guarantees, but considered in the context of the
agreements implementing the assistance package, it does enhance the
likelihood of repayment.
In assessing the likelihood of repayment, the other terms of the
framework agreement should also be considered. Under the framework
and related agreements, Mexico agreed to meet stringent economic
conditions in return for U.S. and IMF assistance. These conditions
provide the United States and IMF with a degree of influence over
Mexican economic policy that did not exist before the onset of the
financial crisis in December 1994. Thus the conditions in the
agreements aim to increase the long-term likelihood that the United
States will be repaid for the loans and securities guarantees. For
example, as a result of the stringent conditions, Mexico's trade
balance was transformed from a large deficit into a surplus during
the first 6 months after the framework agreement was signed. This
rapid turnabout has positive implications for Mexico's future ability
to repay its debts.
--------------------
\12 Other industrial countries, under the auspices of BIS, agreed to
provide a short-term facility of $10 billion, and Canada had already
provided $1 billion in December, under its Canada-Mexico swap
arrangement.
\13 Article IV of the IMF Articles of Agreement.
\14 Under the framework agreement, short-term swaps are available
from the Federal Reserve in an amount up to $6 billion and from ESF
in an amount up to $3 billion.
\15 Sovereign risk is the risk of default by a foreign central
government or an agency it backs.
\16 This example assumes (1) a maturity for Mexican debt securities
of 10 years, principal repayment at the end of 10 years, and interest
payments annually; (2) an interest rate on the debt securities of 6.5
percent per year, comprising Treasury's cost of borrowing of 6.0 per
cent plus a premium of 50 basis points to reflect the fact that these
securities would be less liquid than U.S. Treasury bonds; and (3) a
credit risk premium of 375 basis points.
\17 According to Bank of Mexico data, for three successive weekly
auctions between December 27, 1994, and January 10, 1995, the
quantity of bids fell far short of the amount of tesobonos offered at
auctions for all maturities.
\18 Set-off clauses give the bank or lender a right to seize deposits
owned by a debtor for nonpayment of an obligation.
INITIAL EFFORTS TO RECOVER
FROM THE CRISIS
-------------------------------------------------------- Chapter 0:4.4
The response to Mexico's financial crisis, including the U.S. and
IMF assistance package, has had both positive and negative effects on
Mexico. On the positive side, Mexico's current account deficit is
projected by its Finance Ministry to decline to $215 million in 1995,
down from $29.4 billion in 1994. The trade balance has moved to the
surplus side. Mexico's merchandise trade surplus was $6.1 billion
for the first 10 months of 1995. By the end of August 1995, the
outstanding balance of short-term, dollar-indexed Mexican government
debt had been reduced by about 90 percent. Since the beginning of
1995, the amount of tesobonos outstanding has declined from $29.2
billion to $700 million at the end of November. Mexico's external
debt has been restructured to be longer term. As of December 19,
1995, Mexico's stock market, in peso terms, was about 22 percent
above precrisis levels and about 96 percent above its late February
lows. Interest rates on short-term peso debt declined in August 1995
to about 34 percent, from a high of about 83 percent in March 1995,
and were about 49 percent in December 1995.
These economic improvements were not made without hardship, however,
and the economic measures taken by the Mexican government in
conjunction with the U.S. and IMF assistance packages have had a
severe impact on economic growth in the Mexican economy. Economic
growth for 1995, which was forecasted at the start of the year by the
Mexican government to show a decline of 2 percent for the year, has
been much worse. After declining substantially in the first half of
1995, economic output in the third quarter contracted by 9.6 percent
from the same period a year ago.
The positive developments are critical, since Mexico must restore the
credibility of its economic policies so that it can regain access to
international capital markets. There is evidence that Mexico has
already reestablished some access. On May 4, 1995, Mexico's National
Development Bank was able to sell bonds in an amount of $110.3
million in international capital markets for 1 year at the London
Interbank Offered Rate (LIBOR) plus 3.5 percent.\19 On May 23, 1995,
Mexico's export development bank was able to sell bonds in an amount
of $30 million in international capital markets for 1 year at LIBOR
plus 5.8 percent. On July 20, 1995, Mexico issued $1 billion in
sovereign notes\20 for 2 years at LIBOR plus 5.375 percent in a
private debt offering led by Citibank, Credit Suisse, and the Bank of
Tokyo. The principal and accrued interest of these notes may be
converted into new capital in a newly formed or existing Mexican bank
or tendered as payment for shares in any Mexican privatization.
Other international issues have since followed.
The impact of Mexico's current recession on the financial condition
of Mexico's banking system is still a matter of concern. Mexico's
banks, which were reprivatized in 1991 and 1992, have not resolved
all the problems brought with them from the time they were
nationalized. Moreover, as part of the government economic plan for
responding to the Mexican financial crisis, interest rates have risen
significantly. The increased rates have contributed to an already
high level of nonperforming loans. Delinquent loans as reported by
Mexico rose from a 1994 rate of 9 percent of all bank loans to about
17 percent of all bank loans by the end of September 1995. However,
Mexican banks define nonperforming loans differently than do U.S.
banks. According to a World Bank official, the 17 percent reported
by Mexico would equate to about 27 percent using U.S. generally
accepted accounting principles. Many of the largest Mexican banks
are looking to domestic and foreign investors for capital infusions.
The government of Mexico's response to banking system problems has
several components. The Bank of Mexico provided dollar loans to
banks to replace maturing foreign currency liabilities. These loans,
which rose to as much as $3.8 billion in the early months of 1995,
have been repaid. Also, banks can recapitalize with subordinated
debt issued to the government of Mexico that would either be retired
by the banks within 5 years or converted to stock and sold to private
investors by the government.\21 In addition, the government has
liberalized limits on foreign investment in Mexican banks. Another
Mexican government initiative aims to restructure loans by indexing
principal amounts to inflation so that interest payments can be based
on real interest rates. In addition, the Mexican government, with
the assistance of several sources including the World Bank, has been
adding funds to its banking sector protection fund, which generally
supports the banking system, and is seeking to improve its bank
supervision capabilities.
--------------------
\19 LIBOR is a key interest rate at which major banks in London are
willing to lend to each other. It is often used as a benchmark rate
in international financial transactions.
\20 Sovereign notes are securities issued by countries.
\21 Subordinated debt is repayable in a bankruptcy only after more
senior debt has been repaid.
CHALLENGES REMAIN
-------------------------------------------------------- Chapter 0:4.5
Despite the progress to date, Mexico still faces many difficult
challenges before its financial crisis can be fully resolved.
Interest rates continue to be high, the peso continues to be
volatile, and economic growth is weaker than predicted. For example,
economic growth for 1995, which was forecasted at the start of the
year by the Mexican government to show a decline of 2 percent for the
year, has been much worse. After declining substantially in the
first half of 1995, economic output in the third quarter contracted
by 9.6 percent from the same period a year ago. The banking sector
remains strained, with nonperforming loans having risen to about 17
percent of all bank loans by the end of September 1995 as reported by
Mexico, which would equate to 27 percent using U.S. generally
accepted accounting principles, according to a World Bank official.
Thus, it remains to be seen whether Mexico will be able to maintain
economic policies that will allow the economy to recover from the
crisis.
AGENCY COMMENTS
---------------------------------------------------------- Chapter 0:5
GAO obtained written comments on a draft of this report from the
Treasury Department and the Federal Reserve, who generally agreed
with the report's description of the crisis and the U.S. response.
On December 5, 1995, GAO met with State Department officials,
including the Economics Officer from the Office of Mexican Affairs
and Regional Issues, who generally agreed with the report. GAO also
provided officials from the Bank of Mexico, Mexico's Finance
ministry, the embassy of Mexico, and IMF with portions of the draft
to confirm the accuracy of the presentation of information obtained
from them.
INTRODUCTION
============================================================ Chapter 1
Capital flows to developing countries have increased significantly in
recent years. These increased flows have augmented the possibility
that these countries will see growing financial instability as
developing country governments and private sector firms increasingly
rely on volatile capital investments that can be quickly withdrawn.
Financial and trade reforms in Mexico in the early 1990s led to
increased investor confidence. However, this confidence in Mexico
evaporated at the end of 1994 and the beginning of 1995 as investors
became more and more concerned about domestic Mexican political
events and financial miscalculations. As a result, investors sold
Mexican debt and equity securities, causing foreign currency reserves
at the Bank of Mexico to be insufficient to meet the demand of
investors seeking to convert their pesos to dollars. Mexico's
financial crisis challenged the United States and the International
Monetary Fund (IMF) to react and led to one of the largest
multilateral economic assistance packages to any one country.
CHANGES IN INTERNATIONAL
INVESTING AND GLOBAL FINANCIAL
MARKETS
---------------------------------------------------------- Chapter 1:1
Due to a number of factors, including measures taken to open their
economies to foreign investment, some developing countries\1
experienced significant inflows of capital during the early half of
this decade. Capital flows\2 to these countries, which amounted to
$40 billion in 1990, reached a high of $155 billion in 1993 before
slowing to $125 billion in 1994. Today, emerging markets account for
12 percent of total world equity market capitalization, and their
economies are forecast to grow at about twice the rate of industrial
countries over the period 1995 to 2000.\3
In Western Hemisphere emerging markets, capital flows were more
concentrated in yield-sensitive, liquid portfolios.\4 These
investments accounted for 66 percent of inflows to these markets
between 1990 and 1994 compared to foreign direct investment,\5 which
represented 30 percent. Mexico experienced net capital outflows of
$15 billion in 1983 through 1989, and net inflows of $102 billion in
1990 through 1994. In 1993, Mexico received $31 billion of capital
inflows, which accounted for 20 percent of net capital flows to all
developing countries. These increased capital flows to emerging
markets were the result of several factors: (1) many developing
countries restructured their commercial bank debt and implemented
sounder macroeconomic policies as well as structural reforms in the
1980s and early 1990s, including financial sector reforms such as
placing fewer restrictions on capital flows; (2) cross-border
securities and banking transactions became less costly and more
accessible; (3) institutional investors--mutual funds, insurance
companies, pension funds, and banks and securities firms engaged in
proprietary trading --diversified their portfolios internationally;\6
and (4) interest rates fell in industrial countries, like the United
States, thereby increasing the attractiveness of higher yields in
emerging markets.
--------------------
\1 Emerging markets or developing countries are usually those whose
production sector is dominated by agriculture and mineral resources
and that are in the process of building up industrial capacity. We
use the terms "emerging markets" and "developing countries"
interchangeably.
\2 Capital flows include net foreign direct investment, net portfolio
investment, and bank lending.
\3 See IMF, International Capital Markets: Developments, Prospects,
and Policy Issues (Washington, D.C.: Aug. 1995).
\4 Portfolios are a set of assets held by an individual or
institution. The term is generally used to refer to financial
assets.
\5 Foreign direct investment implies that a person in one country has
a lasting interest in and a degree of influence over the management
of a business enterprise in another country. In some countries, a
minimum percentage of domestic ownership of a foreign company is
required.
\6 In 1993, assets under management by pension funds, insurance
companies, and mutual funds in major industrial countries were about
$13 trillion, with U.S. institutional investors accounting for more
than two-thirds of this total.
PAST ECONOMIC POLICY IN MEXICO
---------------------------------------------------------- Chapter 1:2
Policy decisions that Mexican financial authorities took in 1994 need
to be considered in the context of Mexico's financial and economic
history. From the mid-1970s through the late 1980s, Mexico had been
caught in a destructive cycle of inflation and currency devaluations
that had seriously set back the country's economic development.
Curbing inflation and restoring sustained economic growth was one of
the top priorities of the administration of President Carlos Salinas
de Gortari (1988-94), and a stable exchange rate policy was seen as a
key element in this effort.
MEXICO'S EXCHANGE RATE
POLICY BEFORE 1988
-------------------------------------------------------- Chapter 1:2.1
From 1954 until 1976, Mexico maintained a fixed peso/dollar exchange
rate, at 12.5 pesos per U.S. dollar.\7 This period coincided with an
era of sustained economic development and low to moderate rates of
inflation for Mexico. However, beginning in 1972 the value of the
Mexican peso was increasingly undermined by rising fiscal and current
account\8 deficits and growing inflation. By September 1976,
mounting balance of payments pressures and unbridled capital flight
forced the outgoing administration of President Luis Echeverr�a
(1970-76) to devalue the currency. By the end of the year, the
currency was trading at 21 pesos per dollar. The devaluation was
followed by serious adversities for the Mexican economy. The year
closed with an annual inflation rate of 60 percent, while the country
sank into a severe economic recession.
Under the administration of President Jos� Lopez Portillo (1976-82),
the currency was allowed to depreciate\9 further, to 27.25 pesos per
dollar. During this period, booming oil revenues enabled the Mexican
government to embark on an expansionary economic development policy,
borrowing large sums from abroad. Strong economic growth achieved in
the course of these years was marred by inflation rates that were
high relative to those in the United States and mounting fiscal and
current account deficits. In real terms, the currency gradually
became overvalued.\10
In 1982, the international price for oil fell, and Mexico's access to
foreign borrowing diminished. Faced with dwindling foreign reserves
and massive capital flight, once again an outgoing Mexican
administration resorted to devaluation. This time, the peso was
devalued by almost 500 percent against the dollar over the course of
the year. The country was plunged into a disastrous economic and
financial crisis. Inflation reached an annual rate of over 60
percent. A series of protest strikes and work stoppages paralyzed
economic activity. The Mexican stock market plummeted. The Bank of
Mexico (Mexico's central bank) ran out of foreign currency reserves,
and in August, Mexico temporarily suspended repayment of principal on
its foreign debt. In September, the banking system was nationalized,
and strict exchange rate controls were put in place. By the end of
the year, the peso was traded at 160 per U.S. dollar.
With the leadership of President Miguel de la Madrid (1982-88),
Mexico adopted a dual exchange rate policy. A "controlled" exchange
rate applied to merchandise trade and official debt service payments,
and a "free" rate applied to other types of transactions. The
controlled exchange rate was depreciated daily at the discretion of
Mexican government authorities. Gradually, the controlled rate moved
closer to the free rate. By the end of 1986, the two rates were
quite close, at about 920 pesos per dollar.
Under President de la Madrid, priority was given to repayment of the
huge foreign debt accumulated during the previous administration. As
a result of meeting its debt obligations, Mexico became a net
exporter of capital. The economy was drained of vital financial
resources, and economic development stalled. The devaluation and the
debt service burden, both external and domestic, also placed heavy
inflationary pressures on the economy. By the middle of 1987, Mexico
faced an inflationary crisis, with prices increasing faster than the
currency was depreciating. In November, the Bank of Mexico stopped
intervening in the foreign exchange market, and the currency dropped
to a new low of about 3,000 pesos per U.S. dollar. Again the
Mexican stock market plunged, and annual inflation reached a rate of
159 percent.
--------------------
\7 This is a nominal exchange rate. The nominal exchange rate of a
currency is the actual rate at which one currency can be exchanged
for another currency at any point in time.
\8 A country's current account measures its transactions with other
countries in goods, services, investment income, and other transfers.
\9 Depreciation is a decline in the value of one currency relative to
another in foreign exchange markets. Devaluation is the downward
adjustment in the official exchange rate of a nation's currency.
\10 A change in the real exchange rate of a currency takes into
account the impact of both a change in the nominal exchange rate of
that currency as well as the impact of inflation. For example, if
over the course of a year the inflation rate in Mexico were 20
percent higher than the inflation rate in the United States, and the
peso depreciated in nominal terms relative to the dollar by 20
percent, the real exchange rate of the peso would not change.
However, if the inflation rate in Mexico were 20 percent higher than
the United States, and the peso were to depreciate by only 5 percent,
the real exchange rate of the peso would increase, or appreciate, by
about 15 percent.
ECONOMIC AND FINANCIAL REFORMS
IN MEXICO SINCE 1988
---------------------------------------------------------- Chapter 1:3
Since 1988, the Mexican government has instituted comprehensive
reforms in an effort to make its economy more open, efficient, and
competitive. These reforms addressed both domestic and international
restrictions that limited Mexico's economic growth. Domestically,
these reforms included removing restrictions on foreign investment,
privatizing many state-owned enterprises, and reducing inflation and
government spending. Internationally, Mexico sought to reduce
barriers and expand trade with the rest of the world. These reforms
helped spur a dramatic increase in investments and capital inflows to
Mexico.
PACTO AGREEMENT USED
EXCHANGE RATE STABILITY AS
AN ANCHOR TO CONTROL
INFLATION
-------------------------------------------------------- Chapter 1:3.1
Following the economic upheaval of 1987, Mexican authorities sought
to promote a stabilization plan to break the spiral of inflation and
devaluation that had plagued the country since the mid-1970s.
Stabilization was undertaken within the context of a series of
agreements between the government, labor, and business sectors to
foster social consensus on an evolving package of economic reforms.
These tripartite agreements, which came to be known collectively as
the "Pacto," provided the framework for economic policy under the
administration of President Salinas (1988-1994).
The Salinas administration followed a strategy of economic adjustment
and reforms aimed at reducing the government's role in the economy
and achieving stable-private sector-led economic growth. Although
specific goals and provisions of the Pacto changed over the years, a
commitment to pursue tight fiscal and monetary policies and agreement
on price, wage, and exchange rate policies, remained consistent
themes. Exchange rate stability was regarded as the anchor of the
Pacto, because the commitment to defend an exchange rate requires
prudence in monetary and fiscal policy and provides a stable
environment for investors concerned about currency risk.
Under the Pacto, from March through December 1988 the peso/dollar
exchange rate was fixed. However, in 1989 the fixed exchange rate
was abandoned in favor of a more flexible system that allowed a
gradual depreciation of the peso relative to the dollar. This
system, known as the "crawling peg," provided for an annual
depreciation of the peso of 16.7 percent in 1989, 11.4 percent in
1990, and 4.5 percent in 1991.
Beginning in November 1991, the peso/dollar exchange rate was allowed
to fluctuate within a band that widened daily. The ceiling of the
band was allowed to increase daily to enable the peso to depreciate
at a rate of 0.0002 new pesos per dollar daily, while the floor was
maintained at 3.05 new pesos per dollar.\11 The annual depreciation
rate in 1992 was approximately 2.9 percent. In October 1992, the
ceiling of the band was adjusted, allowing a rate of depreciation of
0.0004 new pesos daily. This provided for a depreciation rate of
approximately 4.5 percent in 1993. Thus, from the end of 1991 to
August 1994, the new peso/dollar exchange rate depreciated from about
3.08 to about 3.24 pesos per dollar.
--------------------
\11 Since 1993, the Mexican currency has been officially designated
the "nuevo peso" or new peso. One new peso is equal to 1,000 old
pesos.
PESO APPRECIATION
IN REAL TERMS
-------------------------------------------------------- Chapter 1:3.2
The Pacto strategy was successful in reducing inflation from an
annual rate of 159 percent in 1987 to 8 percent by the end of 1993.
However, while the rate of inflation was coming down in Mexico during
these years, it was still well above the rate of inflation in the
United States. Consequently, the peso/dollar exchange rate gradually
appreciated in real terms, even though in nominal terms the peso had
depreciated. The implications of this appreciation for Mexico's
economy were subject to different views. Some economic analysts
argued that by 1994 the peso had actually become somewhat overvalued
and that a slight devaluation was necessary to spur economic growth.
On the other hand, key Mexican financial authorities were not
convinced that the peso was overvalued and pointed to the strong
performance of Mexican exports as proof. The concept of currency
devaluation had also become very unpopular in Mexico following the
disastrous experiences of the 1970s and 1980s.
PRIVATIZATION OF GOVERNMENT
ENTERPRISES
-------------------------------------------------------- Chapter 1:3.3
Under the Salinas administration, Mexico continued a process of
divesting itself of various government-owned enterprises. As of
November 1994, the number of state-owned enterprises had declined
from 1,155 in 1982 when divestiture started, to 215 as of November
1994. During this process, several major institutions have been
privatized, including 18 commercial banks and the telephone monopoly
Tel�fonos de Mexico (TELMEX).
OPENING FOREIGN INVESTMENT
IN MEXICO
-------------------------------------------------------- Chapter 1:3.4
In May 1989, Mexico established a new set of regulations governing
foreign investment that eased restrictions on foreign ownership and
investment in Mexico. The new regulations increased the range of
investments available to 100-percent foreign ownership. Further,
under certain conditions, the new regulations did not require
investors to seek approval from the Mexican government. Throughout
1989 and early 1990, the government made adjustments in the
regulations governing foreign investment in petrochemicals, state
banking, and insurance. After the decision to reprivatize banks was
formally announced in May 1990, restrictions on foreign ownership in
financial institutions were relaxed. Stock brokerage houses,
financial groups, and banks were allowed up to 30 percent foreign
ownership.\12
--------------------
\12 Nora Lustig, Mexico: The Remaking of an Economy, The Brookings
Institution, Washington, D.C.
MEXICAN REFORMS INCREASED
INVESTMENT
-------------------------------------------------------- Chapter 1:3.5
Mexico's financial reforms successfully generated international
interest in Mexico in the early 1990s, attracting about $93 billion
in net capital inflows during 1990 through 1993, according to IMF.
However, foreign capital inflows during this period were more heavily
weighted to relatively liquid portfolio investment rather than to
foreign direct investment. Portfolio investment during 1990 through
1993 constituted 60 percent of foreign capital inflows, compared to
about 18 percent for foreign direct investment.
The private sector particularly benefited from the surge in capital
inflows during the early 1990s. The Mexican Stock Market Law of
December 1989 opened up access to Mexico's equity markets and
resulted in large inflows of foreign capital. Before the 1989 law,
the ability of foreigners to participate in Mexico's equity markets
was restricted, and therefore foreign capital had amounted to about 6
percent of Mexico's equity market capitalization. However, due to
liberalization and subsequent high returns on Mexican equity
investments, equity markets attracted inflows of $23 billion during
1990 through 1993. By the end of this period, nonresident investors
accounted for 27 percent of the capitalization of the Mexican equity
market. Private sector bond placements also benefited from
increasing interest in Mexico, attracting $14 billion during this
period, according to IMF.
TRADE LAWS WERE LIBERALIZED
-------------------------------------------------------- Chapter 1:3.6
Mexico has taken several important steps toward relaxing its trade
regime over the past decade by entering into both multilateral and
regional trade agreements. Mexico initiated trade reform in mid-
1985. By 1986, Mexico had initiated fundamental changes to its trade
laws, which paved the way for their entry into the General Agreement
on Tariffs and Trade (GATT).\13 Before these reforms, more than 90
percent of domestic production was protected by a system of import
licenses. By December 1987, measures were introduced to reduce
overall tariff levels to a maximum of 20 percent. By 1988, the
amount of domestic production protected by import licenses stabilized
at about 20 percent.
--------------------
\13 Created in 1947, GATT was the primary multilateral agreement
governing international trade and was founded on the belief that more
liberalized trade would help economies of all nations grow. In 1994
GATT was replaced by the World Trade Organization. See The General
Agreement On Tariffs And Trade: Uruguay Round Final Act Should
Produce Overall U.S. Economic Gains (GAO/GGD- 94-83a;
GAO/GGD-94-83b, July 29, 1994).
TRADE AGREEMENTS WERE SIGNED
-------------------------------------------------------- Chapter 1:3.7
Over the past decade, Mexico has made significant advances in opening
its borders to international trade. Before 1982, large portions of
the Mexican economy were virtually closed to foreign competition
because of the tariff and nontariff barriers that were in place. A
major step toward opening its borders came in 1986, when Mexico
became a full member of GATT. This step resulted in important
reductions in the type of protection traditionally provided to
domestic producers. In addition to joining GATT, Mexico also entered
into several other multilateral and regional trade agreements that
served to improve its trading relationship with other countries.
Since 1992, Mexico has entered into several free trade agreements
with other Latin American countries including Chile, Costa Rica, El
Salvador, Guatemala, Honduras, and Nicaragua. Mexico has also taken
important steps to improve its relations outside of Latin America.
For example, in November 1993, Mexico joined the Asia-Pacific
Economic Cooperation (APEC) Pact, which promotes open trade and
economic cooperation in the Asia-Pacific region.
In April 1994, Mexico became the twenty-fifth member to join the
Organization for Economic Cooperation and Development (OECD). OECD
is a forum for the discussion of common economic and social issues
confronting member countries.\14 The OECD's fundamental objective is
to achieve the highest sustainable economic growth and employment and
a rising standard of living in member countries while maintaining
financial stability and thus contributing to the world economy.
--------------------
\14 OECD members include Australia, Austria, Belgium. Canada,
Denmark, Finland, France, Germany, Greece, Iceland, Ireland, Italy,
Japan, Luxembourg, Mexico, the Netherlands, New Zealand, Norway,
Portugal, Spain, Sweden, Switzerland, Turkey, the United Kingdom, and
the United States.
NORTH AMERICAN FREE TRADE
AGREEMENT (NAFTA)
---------------------------------------------------------- Chapter 1:4
On January 1, 1994, Mexico took another major step toward opening its
markets as it joined the United States and Canada in initiating
NAFTA. NAFTA created the world's largest free trade zone, with 380
million people producing nearly $8 trillion worth of goods and
services. NAFTA's broad goal is to improve productivity and
standards of living through the free flow of commerce in goods,
services, and investment capital throughout North America. To
accomplish this, NAFTA provided for the gradual removal of tariffs
and other barriers to trade and established principles designed to
protect North American investors from arbitrary interference by
governments. In addition, NAFTA established a comprehensive set of
principles and rules governing trade and investment in financial
services. Under NAFTA, U.S. financial services providers are to be
granted access to Mexico and, in general, are to be accorded the same
rights and protections as are Mexican institutions.\15
--------------------
\15 See North American Free Trade Agreement: Assessment of Major
Issues (GAO/GGD-93-137 vols. 1 and 2, Sept. 9, 1993).
NAFTA'S FIRST YEAR
-------------------------------------------------------- Chapter 1:4.1
According to the U.S. International Trade Commission (ITC), NAFTA's
first year resulted in "vigorous" trade and investment expansion
among the three participants. The Bank of Mexico also noted a
"substantial increase" in the total trading volume between Mexico and
its NAFTA partners. NAFTA's implementation resulted in the immediate
elimination of duties on approximately one-half of U.S. exports to
Mexico. Under NAFTA, Mexico launched a 15-year phase- out period
during which Mexico is to reduce its remaining tariffs. Mexico also
started removing the remaining barriers to trade in goods, services,
and foreign direct investment.
OBJECTIVES, SCOPE, AND
METHODOLOGY
---------------------------------------------------------- Chapter 1:5
OBJECTIVES
-------------------------------------------------------- Chapter 1:5.1
In response to a request from the Chairman of the House Committee on
Banking and Financial Services, we (1) examined the origins of
Mexico's financial crisis; (2) assessed the extent to which the U.S.
government and IMF were aware of the severity of Mexico's financial
problems and the extent to which they provided key financial advice
to Mexico throughout 1994; (3) described the U.S. and international
response to the crisis, which included providing an analysis of the
statutory authority for the Secretary of the Treasury to use the
Exchange Stabilization Fund (ESF)\16 to finance the assistance
package, and an assessment of the terms and conditions of the
agreements implementing the U.S. portion of the assistance; and (4)
described the initial efforts of Mexico to recover from the crisis,
which included a discussion of Mexico's access to international
capital markets.
--------------------
\16 In the past ESF has been used to buy and sell foreign currencies,
extend short-term swaps to foreign countries, and guarantee
obligations of foreign governments. ESF's use must be consistent
with U.S. obligations in IMF regarding orderly exchange arrangements
and a stable system of exchange rates.
SCOPE
-------------------------------------------------------- Chapter 1:5.2
To achieve these objectives, we reviewed documents and spoke with
officials about
risks in international finance;
the history of financial assistance for Mexico;
recent economic and financial reforms in Mexico;
economic factors leading to Mexico's financial crisis including
macroeconomic policy, exchange rate policy, foreign exchange
reserves, debt financing, and current account balance;
the awareness of Treasury, Federal Reserve, and State Department
officials of Mexico's financial situation;
advice given to Mexican government officials by Treasury, Federal
Reserve, and State Department officials;
political factors contributing to the loss of investor confidence
in Mexico;
the financial health of the Mexican banking system;
U.S., IMF, Bank for International Settlements (BIS), and Canadian
assistance packages, including the packages' legality,
objectives, funding, and terms and conditions;
criticisms of the U.S. assistance package;
Mexico's post-crisis economic plan;
implementation of the U.S. assistance package; and
the initial effects of the crisis on the Mexican economy and
Mexico's ability to borrow on international capital markets.
METHODOLOGY
-------------------------------------------------------- Chapter 1:5.3
We reviewed documents collected from U.S. and Mexican government
organizations, international organizations, and private firms. These
documents included books, correspondence, legislation, memoranda,
regulations, reports, cable traffic, and testimony. We received
copies of or were given access to all U.S. government documents that
were provided to the House of Representatives as required by U.S.
House Resolution 80. House Resolution 80 required the executive
branch to provide all documents relating to the U.S. assistance
package, including documents relating to the status of the Mexican
economy; contacts between the Mexican government and the Treasury
Secretary or international lending organizations; disbursements from
ESF; the legal basis for using ESF for this purpose; and assessments
of the collateral offered by the Mexican government. These documents
represented over 15,000 pages of information. We did not verify the
accuracy of this information.
To review this vast amount of information, we developed categories in
which to organize the information contained within each document.
The categories were divided into three major sections: (1)
background of the crisis, (2) the crisis of 1994-95, and (3) response
to the crisis. Under "background of the crisis," we used the
following categories:
history of support,
Mexican reforms,
NAFTA, and
miscellaneous background information.
Under "crisis of 1994-95," we used the following categories:
political factors,
investor confidence,
investment flows,
current account,
foreign exchange reserves,
peso valuation,
macroeconomic policies,
advice to Mexico,
Mexican banks,
past crisis comparisons, and
miscellaneous crisis information.
We also reviewed documents listed in this report's selected
bibliography and read related documents at the Central Intelligence
Agency (CIA). Further, we attended several conferences focusing on
Mexican economic issues. To prepare our legal analysis, we reviewed
relevant U.S. government agency legal opinions and related agency
documents, U.S. statutes, and legislative history. Information on
foreign law in this report does not reflect our independent legal
analysis but is based on interviews and secondary sources.
We interviewed U.S. government officials from
the Federal Reserve System (FRS);
the Department of State, both in Washington, D.C., and in the U.S.
embassy in Mexico City; and
the Department of the Treasury, both in Washington, D.C., and in
the U.S. embassy in Mexico City.
We interviewed government of Mexico officials from
Mexico's Finance ministry (Secretaria de Hacienda y Credito
Publico),
the Bank of Mexico,
Mexico's Foreign ministry (Secretaria de Relaciones Exteriores),
the Mexican Banking and Securities Commission (Comision Nacional
Bancaria), and
two government-sponsored development banks in Mexico (Banco
Nacional de Comercio Exterior and Nacional Financiera).
We interviewed individuals from international organizations including
IMF.
We interviewed international investors and investment experts from
the Mexican stock exchange (Bolsa Mexicana de Valores),
the Mexican Investment Board,
the two largest commercial banks in Mexico,
international and Latin American economic experts at universities
and private research and consulting organizations,
two U.S.-based global bond and equity funds with sizable
investments in Mexico,
seven U.S.-based investment and commercial banks, and
one European-based bank.
We conducted our work between March and December 1995 in accordance
with generally accepted government auditing standards.
AGENCY COMMENTS
---------------------------------------------------------- Chapter 1:6
We obtained written comments on a draft of this report from the
Treasury Department and the Federal Reserve, who generally agreed
with the report's description of the crisis and the U.S. response.
(See appendixes II and III.) Their suggested clarifications and
technical changes have been incorporated in the text where
appropriate. On December 5, 1995, we obtained oral comments on a
draft of this report from State Department officials, including the
Economics Officer from the Office of Mexican Affairs and Regional
Issues, who generally agreed with our report. They suggested minor
clarifications which have been incorporated as appropriate. We also
provided officials from the Bank of Mexico, Mexico's Finance
ministry, the embassy of Mexico, and IMF portions of the draft to
confirm the accuracy of the presentation of information obtained from
them. Their technical changes and editorial suggestions have been
incorporated in the text where appropriate.
ORIGINS OF MEXICO'S 1994-95
FINANCIAL CRISIS
============================================================ Chapter 2
The origins of Mexico's financial crisis can be found in the
interplay of a number of complex economic and political factors
during 1994. The market-opening reforms undertaken by the Salinas
administration, coupled with its exchange rate policy, had led to an
increase in foreign investment that helped finance an increase in
Mexico's imports--resulting in an expanding current account deficit.
A series of political developments and high-profile crimes during the
early months of 1994 had weakened Mexico's image of stability and
modernity among investors. These events culminated in the
assassination of the leading presidential candidate, which provoked a
massive loss of foreign reserves. After this tragedy, the government
was temporarily able to stem the loss of foreign reserves. However,
in an attempt to ensure economic growth during the months leading up
to the presidential election, the government pursued macroeconomic
policies that became increasingly inconsistent with its exchange rate
policy and failed to deal with the current account deficit.
Following the election, a new series of political shocks led to
renewed capital flight, and eventually foreign reserves declined to
the point that the authorities could no longer defend the established
exchange rate through intervention.\1 Finally, in the process of the
transition to a new government, the newly appointed team that was
responsible for Mexico's financial affairs committed a series of key
errors that contributed to the financial crisis.
--------------------
\1 The exchange rate can be defended by a country in foreign exchange
markets by a country's purchase of its own currency with its foreign
exchange holdings or by other economic measures.
CERTAIN WEAKNESSES EMERGED IN
MEXICAN ECONOMY TOWARD END OF
THE SALINAS ADMINISTRATION
---------------------------------------------------------- Chapter 2:1
The reforms discussed in chapter 1 transformed the Mexican economy,
but these market-opening alterations generated a new set of
challenges for financial authorities toward the end of President
Salinas' term in office. Mexico's mounting current account deficit,
in particular, emerged as a troublesome issue for the Mexican economy
during this period. The growth in the current account deficit, in
turn, was closely linked to a decline in the private sector savings
rate and a progressive real appreciation of the currency. In
addition, Mexico's banking system, which had been reprivatized under
Salinas, was fragile and was perceived as presenting a constraint on
the use of monetary policy to support the peso or to bring down the
current account deficit.
MOUNTING CURRENT ACCOUNT
DEFICITS ACCOMPANIED
MEXICO'S OPENING TO
INTERNATIONAL TRADE AND
INVESTMENT
-------------------------------------------------------- Chapter 2:1.1
Under the Salinas administration, Mexico sought to stimulate economic
growth and competitiveness by encouraging international trade and
investment. Certain economic indicators illustrate the effects of
this strategy. Mexican merchandise exports almost doubled, from $31
billion in 1988 to $61 billion in 1994. Moreover, Mexico diversified
its export base away from oil exports. During this period, the share
of export earnings derived from oil products dropped from 21 percent
to 12 percent. Mexico also attracted significant levels of foreign
investment. According to the Bank of Mexico, from 1988 to 1994,
Mexico drew in foreign investment amounting to $102.8 billion, out of
which $30.2 billion was foreign direct investment. These high levels
of investment allowed significant capital accumulation in the Mexican
economy. During this time, foreign reserves increased from $6.4
billion to $24.5 billion. While these high levels of foreign
investment allowed significant capital accumulation, they also fueled
a boom in the Mexican stock market. There were also significant
gains in productivity, which increased by an average rate of about 7
percent annually from 1988 to 1994.
However, these reforms entailed opening Mexico's own market to
foreign products and by 1990, the total value of merchandise imports
exceeded the value of Mexican exports. From 1990 to 1994, the
country's annual trade deficit grew from about $1 billion to $18.5
billion. The large inflow of foreign investment capital financed a
tremendous surge in private sector consumption. Consequently,
Mexico's current account deficit grew from 1.4 percent of gross
domestic product (GDP) in 1988 to 7.7 percent of GDP by 1994. (See
fig. 2.1.)
Figure 2.1: Mexico's Current
Account Deficit, 1988-94
(See figure in printed
edition.)
Source: Bank of Mexico.
Mexican financial authorities told us that they were not alarmed by
the mounting current account deficit. They noted that many countries
with dynamic economies have sustained current account deficits for
many years. They also called attention to the dynamic growth in
Mexican exports and improvements in productivity over recent years,
which suggested that the large current account deficit was a
temporary situation that would be corrected in the long run.
Nevertheless, Mexico's current account deficit had grown particularly
large in relation to its GDP,\2 and some financial analysts argued
that such a high deficit could not be sustained over the long run.
These analysts pointed out that Mexico's current account deficit was
financed by the large influx of foreign capital. During the period
1990 to 1993, foreign capital was predominantly portfolio investment
in Mexican stocks and bonds, rather than direct investment in fixed
assets, such as factories. Portfolio investment is more liquid than
direct investment and can be more easily withdrawn by investors.
Consequently, the large current account deficit made the Mexican
economy particularly vulnerable to investors' willingness to maintain
their assets in Mexico. If financial markets' perception of Mexico
changed, and investors withdrew their capital, the country would
encounter difficulties in financing its current account deficit.
--------------------
\2 Mexico's current account deficit as a percentage of GDP was very
large for a developing country. For example, according to IMF data,
Mexico's current account deficit from 1990 through 1993 averaged 5
percent of GDP. This figure is considerably higher than those of
other large Latin American economies. Argentina had current account
deficits averaging 1.9 percent of GDP, while Brazil had an average
current account surplus of 0.1 percent.
DECLINE IN MEXICAN PRIVATE
SAVINGS ADDED PRESSURE ON
CURRENT ACCOUNT DEFICIT
-------------------------------------------------------- Chapter 2:1.2
According to the World Bank and other economic analysts, a key factor
that contributed to Mexico's burgeoning current account deficit was
the decline in the country's private domestic savings. As economic
reforms proceeded during the early 1990s, Mexicans began shifting
more of their income from savings to consumption. According to Bank
of Mexico data, the private sector savings rate, which had been
around 16 percent in 1989, had declined to less than 9 percent by
1992 and had only risen to around 12 percent by 1994. However, in
spite of the decline in private domestic savings, a Bank of Mexico
official noted that foreign investment allowed a substantial capital
accumulation during the early 1990s. (See fig. 2.2.)
Figure 2.2: Mexico's Private
Domestic Savings Rate as a
Percentage of GDP, 1987-94
(See figure in printed
edition.)
Source: Bank of Mexico.
Several explanations have been advanced by economists for the shift
from savings to consumption, including (1) pent-up demand after years
of austerity during most of the decade of the 1980s and (2) the
attraction of cheaper foreign products that became available as
Mexico opened its markets. In any event, the decline in domestic
savings was reflected in increased demand for imports, which put
additional pressure on the current account deficit. Moreover,
imports were directed toward consumption rather than investment.
This made the current account deficit even less sustainable because
less was being invested for long-term growth.
CURRENT ACCOUNT DEFICIT
DETERIORATED AS PESO BECAME
INCREASINGLY OVERVALUED
-------------------------------------------------------- Chapter 2:1.3
As noted in chapter 1, exchange rate stability was regarded as the
anchor of the Pacto. Thus, from 1988 through the end of 1994, the
Mexican government pursued an exchange rate policy that sought to
provide this stability. It did so by initially fixing the
peso/dollar exchange rate and subsequently allowing a controlled
nominal depreciation of the peso against the dollar. Through most of
this period, the government's exchange rate policy was successful in
restoring economic stability, attracting foreign investment, and
reducing inflation. However, certain economists outside Mexico began
to argue that this strategy had also led to a progressive
overvaluation of the currency, restricted export expansion, and
stifled growth.
According to these economists, one reason for the progressive
overvaluation of the peso was that the nominal depreciation allowed
by the Mexican government over this period fell short of the
inflation differential between the United States and Mexico.
Although the rate of inflation was declining in Mexico during these
years, it was still well above the rate of inflation in the United
States. Consequently, the peso/dollar exchange rate gradually
appreciated in real (inflation-adjusted) terms, even though the peso
had depreciated in nominal terms. With an overvalued peso, Mexicans
demanded more imports than they would otherwise have been able to
afford. Conversely, even though Mexican exports experienced one of
the highest rates of growth worldwide, these economists argued that
the overvalued peso limited the growth exports would otherwise have
enjoyed. Thus, the progressive appreciation of the peso and its
overvaluation over this period led to further deterioration of the
current account deficit. (See figs. 2.3 and 2.4.)
Figure 2.3: Average Annual
Peso/Dollar Exchange Rate,
1988-94
(See figure in printed
edition.)
Note: All exchange rates are expressed in terms of new pesos.
Exchange rates from 1988 to 1992 were converted from old pesos to new
pesos. Old pesos were valued in 1,000's/dollar.
\a The peso/dollar exchange rate on December 31, 1994, was 5.325.
Source: Bank of Mexico.
Figure 2.4: Real Peso/Dollar
Exchange Rate Index, 1988-93
(See figure in printed
edition.)
Note: The base year is 1988. This index shows the percentage
increase in the peso value of the dollar when the nominal exchange
rate has been adjusted for inflation in both Mexico and the United
States. For example, the real peso/dollar exchange rate was 41
percent higher in 1993 than in 1988.
Source: CIEMEX-WESA.
In mid-1994, two economists argued that Mexico needed to take action
to adjust the exchange rate to compensate for the overvaluation of
the peso.\3 A 20-percent devaluation of the exchange rate would have
reduced the current account deficit to more manageable levels.
However, according to Treasury officials, this view was not shared by
many private economists who thought that only a small adjustment in
the exchange rate was needed. Mexican financial authorities
explained to us that they were not convinced that the peso was
overvalued at that time. They cited as evidence the strong
performance of Mexican exports and productivity gains.\4 Some Mexican
officials also noted that the concept of currency devaluation had
become very unpopular in Mexico following the disastrous experiences
with devaluations in 1976, 1982, and 1987. Thus, the Mexican
government was not prepared to consider calls for a devaluation.
--------------------
\3 See Rudiger Dornbusch and Alejandro Werner, "Mexico:
Stabilization, Reform, and No Growth," Brookings Papers on Economic
Activity (Washington, D.C.: The Brookings Institution, 1994).
\4 See Banco de Mexico, Report on Monetary Policy: January 1, 1995 -
December 31, 1995, January 1995, pp. 11-14.
CONCERN FOR FRAGILE BANKING
SYSTEM PRECLUDED USING
MONETARY POLICY TO REDUCE
CURRENT ACCOUNT DEFICIT
-------------------------------------------------------- Chapter 2:1.4
Mexican private and government sources agree that following the
nationalization of banks in 1982, commercial banks in Mexico had
become somewhat inefficient due to a lack of competition within the
financial sector. A Bank of Mexico official told us that although
they were denationalized, commercial banks lacked appropriate risk
evaluation systems to assess loans. He also noted that bank loans
were biased in favor of consumer credit, which had exploded after
1989. This combination had led to a high ratio of overdue loans in
commercial banks' portfolios. IMF documents show that as the banks
were being privatized, the ratio of overdue loans had been
increasing. Thus, the percentage of past due loans increased during
December 1991 to March 1994, from 3.5 percent to 8.5 percent. This
deterioration in the quality of assets weakened the banks.
According to Bank of Mexico officials, the fragile state of Mexican
commercial banks during 1994 presented a serious challenge to
financial authorities' ability to use monetary policy to decrease the
current account deficit.\5 One Bank of Mexico official told us that
the decision not to increase interest rates beyond a certain point
was undertaken in large measure to protect Mexico's weak, newly
privatized commercial banks at a critical point in their development.
The situation facing commercial banks in the spring of 1994 was
exacerbated by the slowdown in the Mexican economy in 1993, which had
increased the ratio of nonperforming (past due) loans in their
portfolios. Due to the large ratio of nonperforming loans, Mexican
commercial banks in 1994 were charging interest rates about 15-20
percentage points above the interest rate on "cetes" (cetes provide
the benchmark 28-day interest rate for Mexico).\6 If interest rates
for cetes were allowed to increase too much, however, there was a
risk of increasing the ratio of nonperforming loans for commercial
banks because most commercial bank loans in Mexico have variable
interest rates. According to this Bank of Mexico official, this was
a situation Mexican financial authorities wanted to avoid because it
could have threatened the viability of the entire commercial banking
system.
--------------------
\5 Contractionary monetary policy, which raises interest rates,
causes a decrease in demand for imports, which can lead to a decrease
in the current account deficit.
\6 Cetes are short-term, peso-denominated, Mexican government
treasury certificates.
POLITICAL DEVELOPMENTS DURING
EARLY 1994 RAISED CONCERNS
ABOUT MEXICO'S STABILITY
---------------------------------------------------------- Chapter 2:2
While the Mexican economy underwent a process of comprehensive
economic reform during the late 1980s, Mexico's political system was
basically unaltered under the Salinas administration. However, as
the 1994 presidential elections approached, the government came under
increasing pressure from opposition parties, reform elements within
the ruling party, and other critics to undertake reforms in the
country's electoral system that would allow a fair and open election.
The beginning of 1994 also coincided with a guerrilla uprising in the
southern state of Chiapas. The guerrillas demanded political and
social reforms to address the grievances of the local rural
population. The course of the presidential elections, the uprising
in Chiapas, and two high-profile kidnappings committed during the
early part of 1994 set the stage for a heightened level of anxiety
among investors about Mexico's overall and long-run political
stability.
INSTITUTIONAL REVOLUTIONARY
PARTY'S (PRI) CONTROL OF
ELECTORAL PROCESS CRITICIZED
BY OPPOSITION
-------------------------------------------------------- Chapter 2:2.1
Widespread concerns about Mexico's presidential elections centered on
whether the governing PRI, which had ruled Mexico for over 60 years,
would allow the conduct of fair and open elections. Following past
presidential elections, questions had been raised regarding PRI's
control over and manipulation of the electoral process. Opposition
parties had become particularly strident in their charges of
electoral fraud after the election of President Salinas in 1988,
which PRI had won by a very narrow margin.
CHIAPAS REBELLION DAMAGED
MEXICO'S IMAGE
-------------------------------------------------------- Chapter 2:2.2
On January 1, 1994, armed guerrillas of the Zapatista Army of
National Liberation (EZLN)\7 seized several towns in the southern
Mexican state of Chiapas, demanding "true democracy" and attention to
issues affecting the local peasant population. The attack was timed
to coincide with the entry into force of the NAFTA agreement. The
uprising was a significant blow to Mexico's image as a stable and
mostly conflict-free modernizing country seeking to join the
developed world by enacting economic reforms and by joining NAFTA.
(See fig. 2.5.)
Figure 2.5: Selected Political
and Economic Events, January
1994 - March 1994
(See figure in printed
edition.)
Source: GAO analysis.
The Mexican government responded to the uprising by sending federal
troops to Chiapas. The government also sought to negotiate a quick
settlement of the conflict. In mid-January, the Mexican Congress
passed legislation granting amnesty to anyone involved in violence to
that date. President Salinas also replaced the Interior Minister, a
former governor of Chiapas, with a respected human rights advocate,
Jorge Carpizo. Notwithstanding these conciliatory moves, EZLN held
out for government compliance with all of the movement's conditions.
Both sides agreed to a cease-fire, but the region remained tense
throughout 1994.
Meanwhile, some EZLN proposals resonated among other sectors of
Mexican society, and various groups announced support for the
movement's demands. On January 27, in an effort to deal with these
broader political issues, the government and eight political parties
agreed on a Pact for Peace, Justice, and Democracy, which included a
proposal for electoral reform. The principal elements of the
electoral reform program were to create independent electoral
authorities, provide all parties with more equitable access to the
media, and prohibit the use of public resources by any one party. In
a separate action, the electoral tribunal of Mexico reduced the
maximum allowable presidential campaign expenditure by each party
from $220 million to $43 million. The newly appointed Interior
Minister was charged with overseeing electoral reforms and assuring
the fair conduct of presidential elections.
--------------------
\7 The rebels took the name of Emiliano Zapata, a peasant leader of
the 1910 Mexican Revolution who had called for land reform.
HIGH-PROFILE KIDNAPPINGS
RAISED ADDITIONAL CONCERNS
-------------------------------------------------------- Chapter 2:2.3
Investor concerns regarding Mexico's political stability were also
raised during this time by the kidnapping of two prominent
businessmen. On March 14, 1994, the head of Mexico's largest banking
group (Banamex-Accival) was kidnapped and held for an undisclosed
ransom. Following this incident, the Mexican stock market fell 81
points, apparently out of fear that the kidnapping was linked to the
Chiapas uprising or had some other political motivation. The
businessman was released on June 28, 1994, following reports that a
high ransom had been paid. On April 25, another wealthy businessman
was kidnapped in Mexico City. Following this abduction, President
Salinas attempted to calm the fears of the business community and
investors by creating a new agency to coordinate public security.
The businessman was eventually released on August 5, 1994.
CAPITAL FLIGHT CAUSED BY
POLITICAL AND ECONOMIC EVENTS
---------------------------------------------------------- Chapter 2:3
Mexico's large current account deficit had placed the economy in a
vulnerable position, subject to investors' willingness to maintain
their assets in the country. However, political developments during
the early part of 1994 had begun to raise doubts about Mexico's
long-term stability. The situation came to a head on March 23, 1994,
when PRI's presidential candidate, Luis Donaldo Colosio, was
assassinated while campaigning in Tijuana. Following the
assassination, Mexico experienced large losses in foreign exchange
reserves. In response to this crisis, the Mexican government adopted
a strategy to stabilize foreign reserves in the short run and sought
financial support from its North American Free Trade Agreement
(NAFTA) partners. The government's strategy succeeded in bringing
temporary stability to the economy, but political uncertainty
continued.
FINANCIAL MARKETS REACTED
ADVERSELY TO COLOSIO'S
ASSASSINATION
-------------------------------------------------------- Chapter 2:3.1
The murder of such a high-level political figure as Colosio was
unprecedented in recent Mexican history.\8 As the PRI candidate,
Colosio had been the front-runner in the presidential race and was
almost certain to have become president. Colosio's assassination, in
conjunction with continuing unrest in the state of Chiapas and
concerns about other criminal acts discussed previously, led to fears
of political turmoil in Mexico.
Financial markets reacted immediately. On March 24, President
Salinas, concerned about a run on the peso and the drop in the stock
market, appealed for calm. He then closed banks, currency exchange
houses, and the stock market. This same day, the Federal Reserve and
Treasury announced the availability of a large temporary swap
facility. Nevertheless, the stock market closed down 22 points on
the following day. There was a net outflow of capital in April and a
dramatic loss in foreign reserves. By April 22, barely a month after
Colosio's assassination, foreign reserves had declined by $10.8
billion. (See figs. 2.6 and 2.7.)
Figure 2.6: Mexico's Foreign
Exchange Reserves, July 1993 -
December 1994
(See figure in printed
edition.)
Note: End-of-month data.
Source: Bank of Mexico.
Figure 2.7: Selected Political
and Economic Events, April 1994
- June 1994
(See figure in printed
edition.)
Source: GAO analysis.
--------------------
\8 The last high-level political assassination in Mexico was that of
President Alvaro Obreg�n in 1928.
U.S. INTEREST RATES
INFLUENCED PERFORMANCE OF
MEXICAN FINANCIAL MARKETS
-------------------------------------------------------- Chapter 2:3.2
Before the Colosio assassination, the Bolsa was already experiencing
some volatility. The Bolsa, which is generally tracked by its
published index, the Indice de Precios y Cotizaciones (IPC), reached
a high of 2,881 on February 8, 1994. In mid-February, however, the
Bolsa began to decline. IMF reported that in February 1994, there
was a net equity inflow of $280 million from the United States.
However, in March, U.S. investors sold a net $170 million of Mexican
shares, which accompanied a rapid stock price decline in Mexico. The
Bolsa stock index continued to decline after the assassination before
sliding to its 1994 low on April 20 of 1,957. This was a decline of
37 percent in dollar terms from the February 8 high. (See fig.
2.8.)
Figure 2.8: Mexico's Stock
Market Index, January 1994 -
October 1995
(See figure in printed
edition.)
Source: Mexico's Bolsa (stock market).
Market analysts have noted that although Mexico should have
anticipated a decline in the Bolsa after Colosio's assassination,
investors were more influenced by economic events than by the
tragedy. For example, a U.S. Treasury memorandum reported, at the
time, that rising interest rates in the United States were likely to
have a more profound effect on Mexican markets than was the political
uncertainty caused by the assassination, a view with which many
market analysts concurred. Early in February, the U.S. Federal
Reserve had announced the first of six increases in interest rates
that were to occur during 1994. Mexican stocks reacted badly to the
news, as investors reassessed their Mexican holdings in light of
Mexican interest rates, an anticipated real GDP growth rate of only
0.4 percent, disappointing company earnings reports, and increasing
political uncertainty, according to the Federal Reserve's staff
analysis. Federal Reserve officials told us that Mexican financial
officials failed to anticipate and react to developments in U.S.
monetary policy. These officials also told us that Mexican
authorities made a major mistake when they did not increase interest
rates in anticipation of or immediately after the Federal Open Market
Committee (FOMC) raised the federal funds rate 75 basis points on
November 15, 1994. (See figs. 2.9 and 2.10.)
Figure 2.9: U.S. Federal
Funds Rates, January 1994 -
November 1995
(See figure in printed
edition.)
Source: U.S. Federal Reserve.
Figure 2.10: Interest Rates
for 3-Month U.S. Treasury
Bills, January 1994 - December
1994
(See figure in printed
edition.)
Note: End-of-month data.
Source: U.S. Treasury Department.
At the time, investors did not have access to a reliable futures or
forward market to hedge against currency risk,\9 because Mexico did
not permit the trading of peso futures. According to a Bank of
Mexico official, peso futures trading was attempted in the early
1980s, but the Bank of Mexico was concerned about peso price
volatility. The Bank of Mexico thought that the market was not
serving legitimate hedging interests and that banks were manipulating
the market in a speculative manner. The effect of this absence of a
futures market in Mexico, given the difficulty in hedging forward
positions, heightened the perceived risk of investing in Mexico and
negatively affected investor confidence, according to a 1995 Federal
Reserve memorandum.
--------------------
\9 In either a currency futures or forward market, the future price
of the currency is established at the time of the contract.
IN RESPONSE TO CRISIS,
MEXICAN GOVERNMENT TOOK
ACTION ON VARIOUS FRONTS AND
OBTAINED SUPPORT FROM NAFTA
PARTNERS
-------------------------------------------------------- Chapter 2:3.3
In the aftermath of the Colosio assassination, Mexican authorities
undertook several measures to stabilize financial markets. To begin
with, the Bank of Mexico allowed the peso to continue to rise to the
ceiling of the exchange rate band.\10 Although this action did not
violate the commitment to exchange rate stability, it allowed for a
significant depreciation in the value of the peso. Thus, by April
22, the peso was nearly 8-percent lower against the dollar than in it
was in mid-February. The effect of this depreciation of the peso
within the band was to increase the price of imports and relieve
pressure somewhat on the current account deficit.
The government of Mexico also undertook changes in monetary policy.
Interest rates offered for the benchmark 28-day cetes rose from 9
percent on March 23 to 18 percent by April 20. Mexico's Finance
ministry offered higher interest rates on cetes to attract foreign
investment and offset losses in foreign reserves. In addition, the
government offered foreign investors more dollar-indexed, short-term
securities, known as "tesobonos."
Although cetes carried exchange rate risk for dollar-based investors,
tesobonos were dollar-linked and therefore carried no such exchange
rate risk. This linkage to the dollar meant that at the time of
maturity, tesobonos could be redeemed in pesos for whatever their
original value was in dollar terms plus their interest earnings.
Because the value of tesobonos was linked to the dollar, foreign
investors were spared the foreign exchange risk inherent in holding
cetes as long as they could also be sure that they had little risk of
not being able to convert the pesos into dollars at the prevailing
exchange rate. Mexico could therefore offer much lower interest
rates for tesobonos than for cetes. For example, on April 20, 1994,
the interest rate offered on 91-day tesobonos was only 6.6 percent,
compared to 18 percent for cetes. During the period following the
Colosio assassination, Mexican authorities began shifting the
composition of the country's short-term internal debt from cetes to
tesobonos. Thus, on the last week of April, there was nearly a
sevenfold increase in tesobonos offered and a 57-percent reduction in
cetes.
On April 26, 1994, U.S., Canadian, and Mexican monetary authorities
announced an expanded trilateral "swap" facility to expand the pool
of potential resources available to monetary authorities of each
country to maintain orderly exchange markets.\11 The swap arrangement
was established in connection with the newly formed consultative
group called the North American Financial Group and comprised the
finance ministers and central bank governors of Canada, Mexico, and
the United States. Negotiations on a swap arrangement, totaling U.S.
$6 billion and Canadian $1 billion, were begun in late 1993 but were
only formally concluded on April 26, 1994. The swap arrangement was
to be permanent, and the Federal Reserve was to provide $3 billion
and Treasury's ESF, the other $3 billion. By announcing the swap
arrangement, the NAFTA partners demonstrated confidence in Mexico's
economic policies, expanding the pool of potential resources
available to Mexican authorities to maintain order in financial
markets. The Federal Open Market Committee saw the announcement as
an action that would help confirm continued U.S. support for
Mexico's economic policies at a potentially critical time for Mexican
financial markets. Although initial multilateral discussions of the
swap arrangement predated the Colosio assassination, and the swap
arrangement was originally intended as a complement to NAFTA, the
April announcement of the swap facility may have helped to relieve
pressure on the peso/dollar exchange rate.
--------------------
\10 By allowing the peso to rise to the ceiling set by the exchange
rate band, the authorities were in effect providing for a
depreciation of the peso against the dollar. Most of the
depreciation within the band that occurred after February took place
before the Colosio assassination.
\11 A swap arrangement provides for temporary exchanges of currencies
between participating countries. Partners in the arrangement can
draw on each other's currency by supplying their own currency up to
an agreed amount. The swap is usually reversed within a short period
at the original exchange rate, but may be rolled over.
CONCERNS RAISED ABOUT
OUTCOME OF PRESIDENTIAL
ELECTIONS
-------------------------------------------------------- Chapter 2:3.4
A month after the assassination of Colosio, Mexican authorities had
been largely successful in stabilizing financial markets. Still,
political uncertainty continued in the period leading up to the
elections. Colosio's assassination raised new questions about the
course and outcome of the 1994 presidential elections. For example,
press reports speculated about PRI's ability to find a viable
candidate so close to the elections. A complex set of conditions,
including restrictions regarding past government service and place of
residence, ruled out many potential candidates. Eventually, Ernesto
Zedillo, Colosio's campaign manager, was designated as PRI's new
presidential candidate. However, according to press reports, Zedillo
lacked political experience and initially had difficulty attracting
public support.
Controversy about the course of the elections and reforms continued
throughout the summer. In June, Interior Minister Carpizo resigned,
only to be reinstated after appeals from PRI and other political
parties. His resignation was followed by a temporary decline in
foreign reserve levels.
INCONSISTENCIES DEVELOPED IN
MEXICAN MACROECONOMIC POLICIES
---------------------------------------------------------- Chapter 2:4
The government of Mexico did not address the fundamental weakness in
the Mexican economy, namely the growing current account deficit, by
the measures adopted following Colosio's assassination. During the
period leading up to the August presidential elections, Mexican
financial authorities attempted to maintain economic growth momentum,
putting further pressure on the current account deficit. Gradually,
inconsistencies emerged among monetary, fiscal, and exchange rate
policies.
GOVERNMENT STROVE TO PROMOTE
ECONOMIC GROWTH BEFORE
ELECTIONS
-------------------------------------------------------- Chapter 2:4.1
By the middle of 1994, the Mexican economy was entering an
expansionary phase, partly as a result of government development
banks providing credits that stimulated economic growth. It was also
evident that Mexico's current account deficit would be higher than
that in 1993 unless the government took steps to reduce consumption.
However, according to Mexican officials, with Zedillo trailing in the
polls only 3 months before the presidential election, the government
was reluctant to take any measure that could derail economic growth.
Moreover, Bank of Mexico and Finance ministry officials told us that
they were confident that a successful conclusion to the elections
would restore capital inflows to Mexico and allow financing of the
current account deficit.
In the period leading up to the presidential elections, Mexican
financial authorities adopted exchange rate, fiscal, and monetary
policies that either supported or accommodated economic growth. In
terms of the exchange rate, no further action was taken to correct
for the real appreciation of the currency. Fiscal policy, meanwhile,
became somewhat expansionary as government financial
intermediaries--government development banks and trust funds--pumped
credit into the economy. Monetary policy accommodated the economic
expansion by keeping interest rates low. Although interest rates did
rise somewhat, the rise was not enough for the Bank of Mexico to be
able to defend the peso. These policies became increasingly
inconsistent with each other, adding to an increase in the current
account deficit and postponing action on the overvalued currency.
(See fig. 2.11.)
Figure 2.11: Mexican Policy
Inconsistencies and Economic
Consequences
(See figure in printed
edition.)
Source: GAO analysis.
NO ADJUSTMENTS MADE IN
EXCHANGE RATE POLICY
-------------------------------------------------------- Chapter 2:4.2
According to various economic analysts, in 1994 Mexican authorities
could have attempted to reduce the current account deficit by
adjusting the country's exchange rate. As previously noted, the
article by Dornbusch and Werner\12 argued in favor of this course of
action. They said that despite some productivity growth, Mexico was
experiencing a loss in competitiveness due to the overvaluation of
the currency. However, Mexican officials explained that in the
months leading up to the national elections, the government was not
prepared to do anything that might upset the consensus reached with
business and labor within the context of the Pacto. Moreover, Bank
of Mexico and Finance ministry officials told us they believed that
because of the outstanding performance of Mexican exports in 1994,
arguments by financial analysts that the peso was overvalued were
exaggerated. Consequently, until the end of 1994, the only action on
the exchange rate policy acceptable to Mexican authorities was
allowing the peso to depreciate against the dollar to the maximum
extent allowable within the established exchange rate band.
--------------------
\12 "Mexico: Stabilization, Reform, and No Growth."
FISCAL POLICY STIMULATED
ECONOMIC EXPANSION
-------------------------------------------------------- Chapter 2:4.3
Other economic analysts have argued that Mexican authorities could
also have pursued tighter fiscal policies to reduce the current
account deficit in 1994. The government could have reduced
expenditures to reduce domestic demand, decrease imports, and relieve
pressure on the peso. In effect, the government could have
compensated for the decline in private domestic savings with a
corresponding increase in public domestic savings. This could have
been achieved by raising taxes, or by reducing government
expenditures, or by undertaking a combination of both these measures.
The Mexican government, however, had already undergone several years
of difficult budget cutting, taking the federal budget from a deficit
equal to 9.3 percent of GDP in 1988 to a surplus of 0.7 percent of
GDP in 1993, according to Bank of Mexico data. Moreover, Mexico's
total net public sector debt had been reduced from nearly 50 percent
of GDP in 1988 to about 25 percent of GDP by 1993. Given this
diminishing level of public indebtedness, Mexican authorities argued
that it would have been difficult to pursue a fiscal surplus and
accept high levels of unemployment and slow economic growth. They
further argued that such actions would have had an immediate adverse
impact on economic growth, and this policy change would have been
particularly difficult to achieve in a national election year.
Instead of pursuing a policy of fiscal restraint, the Mexican
government actually increased spending in 1994. Figures on public
sector expenditures for 1994 indicate government spending stimulated
economic growth, particularly in the construction and energy sectors.
Overall budgeted federal expenditures grew by 11.6 percent.
According to the Bank of Mexico, the nonfinancial public sector
economic balance ended in a deficit of 1.1 percent of GDP. The
government also provided considerable credits through financial
intermediaries, such as development banks and trust funds. If this
financial intermediation by government institutions is taken into
account, Mexico's budget deficit for 1994 reached 4.7 percent of GDP.
MONETARY POLICY ACCOMMODATED
ECONOMIC GROWTH
-------------------------------------------------------- Chapter 2:4.4
In order to reduce the current account deficit in 1994, Mexican
authorities could have pursued a more stringent monetary policy, as a
number of economic analysts have noted. In discussions with us and
in various publications,\13 Bank of Mexico authorities have asserted
that throughout 1994 they pursued a monetary policy that was not
expansionary. As evidence that the monetary policy pursued in 1994
was not expansionary, these officials pointed to (1) the modest
growth in the monetary base when compared to the growth of Mexico's
nominal GDP over the course of the year, (2) the relatively low level
of inflation despite economic growth, (3) the high interest rates
that prevailed during much of the year, and (4) the stability of
foreign reserves from April to November. In addition, a Bank of
Mexico official noted that monetary policy was geared toward
supporting the exchange rate regime, which was consistent with
achieving price stability. This official stated that in 1994
inflation was only 7.1 percent, the lowest in 22 years. In
retrospect, however, several economists have argued persuasively that
developments in 1994 suggest that Mexican monetary policy
accommodated economic expansion, and that it was not entirely
consistent with the government's exchange rate policy.\14
As Mexico began losing reserves following the Colosio assassination,
the Bank of Mexico compensated for the effects on the domestic
monetary base of decreases in foreign reserves by increasing domestic
credit.\15 This strategy offset the contractionary impact on the
monetary base caused by the loss of foreign reserves and kept
interest rates from rising to levels that otherwise might have caused
severe economic disruption. According to Bank of Mexico officials,
the newly privatized and weak Mexican banking system would have been
imperiled by such high interest rates. In any event, some economists
noted that by providing credit to the economy in order to compensate
for the loss of foreign reserves, the Bank of Mexico forestalled a
contraction in the monetary base and a rise in interest rates that
would have led to an economic downturn. These economists explained
that even though pursuing tighter monetary policy would have had a
contractionary impact on the economy in the short run, it would also
have led to a reduction of the current account deficit in the long
run.
As noted earlier, Mexican authorities did succeed in stabilizing the
level of foreign reserves by the end of April, and reserves remained
stable until mid-November 1994. This was not achieved primarily
because of strict monetary policy, which would have entailed offering
interest rates high enough to attract and maintain foreign investors.
Investors were demanding higher interest rates on newly issued cetes
because of their perception that the peso would eventually be subject
to a relatively large devaluation. After the Colosio assassination,
interest rates did rise significantly from about 9 percent to about
20 percent. But by the end of April, rates declined somewhat and
remained between 15 and 20 percent until the December crisis. Even
at these interest rate levels, demand for cetes lagged. Instead of
raising interest rates further, the government managed to attract
investors by shifting from peso- to dollar-indexed securities to
finance its internal debt. As illustrated in figures from the Bank
of Mexico, from January to November, foreign investment in tesobonos
rose from 6.4 percent to 70.2 percent of total foreign investment in
Mexican government securities. Conversely, foreign investment in
cetes declined from 70.3 percent to 24.4 percent of foreign
investment in Mexican securities. By shifting from cetes to
tesobonos and assuming the foreign exchange risk for its own
securities, the Mexican government avoided paying the higher interest
rates investors were demanding for holding peso assets. The shift
from cetes to tesobonos forestalled the contractionary impact that
even higher interest rates would have had on the economy. It also
did nothing to reduce the current account deficit. Moreover, as
sales of tesobonos rose, Mexico became vulnerable to a financial
market crisis because many tesobono purchasers were portfolio
investors who were very sensitive to changes in interest rates and
risks. Tesobonos had short maturities, which meant their holders
might not roll them over if investors perceived (1) an increased risk
of a Mexican government default or (2) higher returns elsewhere.
(See fig. 2.12.)
Figure 2.12: Foreign
Investment in Mexican
Government Securities, 1994
(See figure in printed
edition.)
Note: Other debt instruments include ajustabonos (peso-denominated
Mexican treasury bonds that are adjusted for Mexican inflation) and
bondes (peso-denominated Mexican development bonds).
Source: Bank of Mexico.
Mexican officials said that they were aware of the risks involved in
switching from cetes to tesobonos to finance the current account
deficit. By issuing increasing amounts of tesobonos, the government
of Mexico was in effect reducing its ability to maneuver within the
exchange rate policy. Mexican authorities explained that they
pursued this strategy for several reasons. First, Bank of Mexico and
Finance ministry officials were confident that the peso was not
overvalued. They maintained that the boom in Mexican exports and
gains in productivity were not consistent with an overvalued
currency. Second, the strategy had been tried before and had proven
successful. Mexican officials told us that foreign investment in
Mexico had dipped in late October and November 1993 due to the debate
over the vote in the U.S. Congress on legislation to implement
NAFTA. At that time, Mexican authorities had issued more tesobonos
to attract foreign investors. After the success of the NAFTA vote,
investors switched back to cetes, which carried a higher interest
rate (see fig. 2.6). Mexican authorities said they expected that
following the successful conclusion of the presidential election in
August 1994, tesobono holders would once again switch back to cetes.
In addition, Bank of Mexico officials said that they opposed allowing
too dramatic a hike in cetes interest rates because this might have
sent the wrong message to financial markets. They noted that
investors were concerned about the effect higher interest rates would
have on the Mexican banking system and their impact on debtors and
financial intermediaries.
--------------------
\13 See Banco de Mexico, Informe Anual 1994, Banco de Mexico, Mexico
City: April 1995; and Banco de Mexico, The Mexican Economy 1995:
Economic and Financial Developments in 1994 and Policies for 1995,
Banco de Mexico, Mexico City: June 1995.
\14 See Nora Lustig, "The Mexican Peso Crisis: The Foreseeable and
the Surprise," Brookings Discussion Papers in International Economics
(Washington, D.C.: The Brookings Institution, June 1995).
\15 The strategy of compensating for losses or gains in foreign
reserves by respectively increasing or decreasing credit available to
the domestic economy is known as "sterilization." Until February
1994, the Bank of Mexico had sterilized capital inflows by reducing
domestic credit. This was done to combat inflation and relieve
pressure on the current account deficit. When capital started
flowing out, authorities applied this policy in reverse.
RENEWED POLITICAL AND FINANCIAL
INSTABILITY PRECIPITATED
FLOATING OF CURRENCY
---------------------------------------------------------- Chapter 2:5
Expected high levels of investment flows failed to materialize
following the elections in August 1994. Just when stability appeared
to have been restored after the successful outcome of the
presidential election, Mexico was rocked by a new series of political
shocks. Moreover, in the process of the transition to a new
government, the newly appointed team that assumed responsibility for
Mexico's financial affairs committed a series of key errors,
according to Mexican government officials and financial analysts we
interviewed. These errors precipitated further losses in foreign
exchange reserves and eventually provoked a crisis when the decision
was finally made to devalue the peso. (See fig. 2.13.)
Figure 2.13: Selected
Political and Economic Events,
July 1994 - September 1994
(See figure in printed
edition.)
Source: GAO analysis.
POST-ELECTION SURGE IN
INVESTMENT FLOWS FAILED TO
MATERIALIZE
-------------------------------------------------------- Chapter 2:5.1
Mexican financial authorities told us that they expected a turnaround
in investment flows following the election. They stated that they
believed the successful results of the presidential election in
August would reassure investors. Moreover, Mexico's economic
indicators showed positive economic performance for 1994. The
economy was growing, inflation was at the lowest level in over 2
decades, exports were booming, and productivity was up.
Nevertheless, foreign investment flows did not return to Mexico as
anticipated. Some economists have suggested that investors at this
point may still have been reacting to rising U.S. interest rates.
On the other hand, Mexican interest rates had actually declined after
the surge in April and did not increase after the August election.
Interest rates and other external factors made Mexico less attractive
for portfolio investors, according to market analysts. For example,
according to IMF data, real interest rates offered for Mexican
Treasury bills in September through November were only about 4 to 5
percentage points higher than rates on U.S. Treasury bills.
The Bolsa is an indicator of investors' interest in the Mexican
economy. Although the stock market had lost substantial value during
the spring, it began a period of recovery during the summer of 1994
as the political situation stabilized. The Bolsa index rose to about
2,700 in August as it became apparent that the election was not going
to result in political instability; then it climbed to 2,746 by the
end of September. However, the market weakened in the fall, as some
companies reported disappointing results for the third quarter due to
high financing costs when foreign capital flows dried up. The Bolsa
closed at the end of November at 2,591 (see fig. 2.8).
FURTHER LOSSES IN RESERVES
PROVOKED BY POLITICAL
INSTABILITY
-------------------------------------------------------- Chapter 2:5.2
Although the high level of investment flows failed to materialize as
expected, the August election appeared to signal a return of
political stability. Zedillo had won the presidential election with
a comfortable margin, and the election, which had been monitored by
international observers, was declared essentially fair and clean.\16
However, on September 28, 1994, Jos� Francisco Ruiz Massieu,
secretary general of the PRI, was murdered outside a hotel in Mexico
City. This second high-level political assassination, only 6 months
after the murder of Colosio, sent a new shock wave through the
Mexican political system.
Attention was once more drawn to unanswered questions about the
investigation into the Colosio assassination, with speculation in the
press about possible internal struggles and conspiracies within PRI
that had turned violent. The difficult political situation was only
exacerbated in mid-November, when Deputy Attorney General Mario Ruiz
Massieu, who was heading the investigation of his brother's
assassination, accused PRI officials and the Mexican Attorney General
of obstructing the investigation into his brother's assassination.
Eventually, Ruiz Massieu resigned from his post and from PRI. (See
fig. 2.14.)
Figure 2.14: Selected
Political and Economic Events,
October 1994 - December 1994
(See figure in printed
edition.)
Source: GAO Analysis.
In the midst of the unfolding political scandal over the Ruiz Massieu
investigation, renewed hostilities erupted in the state of Chiapas.
The cease-fire that had endured in that state since January was
broken in early December. Violence resumed again as two contenders
for the post of state governor claimed to have won the election.
--------------------
\16 Zedillo of PRI won the election with 50 percent of the valid
votes. Cevallos of the National Action Party (PAN) got 27 percent of
the votes, and Cardenas of the Party of the Democratic Revolution
(PRD) received 17 percent of the votes.
MEXICAN NATIONALS REACTED TO
DETERIORATING SITUATION
BEFORE FOREIGN INVESTORS DID
-------------------------------------------------------- Chapter 2:5.3
A difference in perspective between domestic and foreign investors
regarding financial and political developments may explain the loss
of foreign reserves Mexico began to experience in mid-November. IMF
research indicates that pressure on foreign reserves during this
period came from Mexican residents rather than from the flight of
foreign investors or from speculative position taking. A Mexican
government official expressed serious reservations about the
methodology used by IMF to come to this conclusion. However, some
U.S. market analysts also complained that Mexico's infrequent
release of financial data in 1994, particularly the release of
foreign reserves levels only three times a year, contributed to their
misjudgment of Mexico's financial condition. At the same time, a
Bank of Mexico official told us that experienced analysts could have
calculated the level of foreign reserves by using other Bank of
Mexico data. Some economic analysts suggested that Mexican
investors, who were more sensitive to the deteriorating political
situation and had experience with the pattern of peso devaluation at
the end of previous presidential terms, reacted to events more
rapidly than did foreign investors by trading pesos for dollars
during the final months of 1994. Nevertheless, a Mexican government
official disagreed with these analysts, suggesting that Mexicans were
not better informed than foreign investors were about the financial
situation at the time.
OTHER FACTORS SHAPED
INTERNAL MEXICAN GOVERNMENT
DEBATE ON EXCHANGE RATE
-------------------------------------------------------- Chapter 2:5.4
The political scandal unleashed by the allegations of Ruiz Massieu
renewed apprehension among investors regarding Mexico's political
stability and triggered a new round of capital flight. Foreign
reserves, which on average had remained stable at approximately $16
billion to $17 billion from late April to mid-November, dropped to
less than $13 billion by November 18. Capital flight led to renewed
pressure on the exchange rate. Toward the end of November, key
financial decisionmakers from the Bank of Mexico, the outgoing
Salinas administration, and the administration of President-Elect
Zedillo, met to determine what strategy to pursue on exchange rate
policy. At this time, Mexican financial authorities decided against
devaluing the currency.
According to a published account of events by the former Mexican
Finance Minister, allowing an abrupt fall in the value of the peso
against the dollar, beyond the limits set by the established exchange
rate band, would have led to a loss of credibility and confidence.
At various times during 1994, the Mexican Finance ministry had
assured investors that there would not be a devaluation of the
currency outside the exchange rate band. Instead of devaluing the
currency, Mexican authorities agreed to seek to calm financial
markets by ratifying the government's commitment to exchange rate
stability within the context of renewing the Pacto.
1995 BUDGET PRESENTATION TO
MEXICAN CONGRESS LACKED
CREDIBILITY
-------------------------------------------------------- Chapter 2:5.5
Reaffirming the new administration's commitment to the exchange rate
band on November 20, as part of a reaffirmation of the Pacto,
temporarily halted the drain in foreign reserves. From that date
through the first 2 weeks of December, foreign reserves remained
above the $12-billion level. However, on December 9, the new
administration presented its 1995 budget to the Mexican Congress.
According to Mexican economists and government officials, this budget
was based on unsustainable economic projections; most notably, it
anticipated a significant increase in the current account deficit in
1995.
Mexican economists and government officials told us that the 1995
budget projections caused a great deal of concern in financial
markets. It appeared that the new administration was still unwilling
to address the inconsistencies in Mexican fiscal, monetary, and
exchange rate policies. Mexico would not be able to finance a
current account deficit greater than the one in 1994 as well as
defend the existing exchange rate with the levels of reserves
available in early December 1994. A growth in the current account
deficit was only possible if Mexico could attract sufficiently high
levels of new capital from abroad. But Mexico was not attracting
capital; instead, capital was leaving Mexico.
PESO DEVALUATION MISHANDLED
-------------------------------------------------------- Chapter 2:5.6
Capital flight resumed after the budget presentation, and by the
following week, foreign reserves had dropped below $10.5 billion.
According to Mexican officials, at this time it was clear that the
existing exchange rate could not be maintained, given the dwindling
level of reserves. On December 19, government officials called a
meeting of the parties to the Pacto and proposed allowing the peso to
float. However, according to several Mexican officials, the business
community refused to accept the concept of a floating exchange rate.
Business leaders argued that simply allowing the peso to float would
send the wrong signal to financial markets. Since the market had
overshot on previous devaluations, business leaders wanted to fix the
exchange rate at a reasonable level. The government yielded to
business concerns and agreed to announce a 15-percent depreciation of
the existing exchange rate band, rather than allow the peso to float.
According to former Finance ministry officials and representatives of
several major investment organizations, the December 19 devaluation
was mishandled and provoked a financial crisis that was unwarranted.
The decision to announce a 15-percent depreciation of the currency on
December 19 made matters much worse for Mexico. December 19 was also
marked by fighting in the Mexican state of Chiapas, which renewed
apprehension among investors regarding Mexico's political stability.
During the 2 days that followed, the Bank of Mexico lost nearly half
of the remaining foreign exchange reserves while trying to defend the
new peso/dollar exchange rate. According to Bank of Mexico
officials, allowing the peso to float from the start might have
avoided this loss of foreign reserves.
According to Mexican government officials and academic experts, the
new Mexican administration was also unprepared to handle ensuing
developments. It is traditional in Mexico that a change in
presidents is accompanied by a change in the staff in most
ministries. Consequently, relatively few officials from the prior
administration were left in the Finance ministry to respond to
inquiries from investors regarding the sudden decision to change the
exchange rate policy. One former Finance ministry official noted
that instead of explaining the situation openly to investors, the
government tried to portray its decision as a minor adjustment in the
exchange rate band, rather than as a devaluation. But after repeated
assurances that there would not be a devaluation, this stance on the
part of the government only undermined investor confidence even
further.
After markets closed on December 21, Mexican authorities announced
that they would no longer try to defend the peso/dollar exchange
rate, effectively abandoning the exchange rate band and allowing the
peso to float. Economic analysts we spoke to in the United States
and Mexico agreed that the government made a critical mistake at this
point by failing to put in place an economic adjustment plan to
accompany the decision to float the peso. These analysts argued that
at this point the Mexican government needed to reassure financial
markets that it was prepared to take tough measures to stabilize the
economy and address the adverse economic consequences inherent in a
major devaluation. They said that the government needed to make
public a plan that would have included fiscal restraint, a
restrictive monetary policy, and negotiation of a line of credit from
IMF. But no such measures were taken or announced for several weeks
following the decision to float the peso. According to several U.S.
government officials and Wall Street investment analysts, during this
time the initial anxiety over the value of the peso turned into a
general sense among investors that Mexico might be forced to default.
DEVALUATION DEGENERATED INTO
FINANCIAL CRISIS BY JANUARY
1995
---------------------------------------------------------- Chapter 2:6
DELAYS IN DECISIVE ACTION
EXACERBATED FINANCIAL CRISIS
-------------------------------------------------------- Chapter 2:6.1
After the peso was allowed to float, market analysts believed that
the government of Mexico needed to take steps to restore investor
confidence and regain financial stability. This was especially
important because, as the Mexican Finance Minister has stated, the
mechanics of the devaluation were badly timed and badly executed.
Events after the devaluation did not lead international financial
markets to conclude that Mexico was stable, however. To the
contrary, according to U.S. officials and Wall Street market
analysts, investors became increasingly skeptical about Mexico's
financial future in light of the Mexican government's response to the
crisis. For example, one analyst told us that the Mexican government
appeared unwilling to allow interest rates to rise to market levels
and, as a result, many investors sold their securities.
A significant influence on investors was information emerging on
Mexico's remaining reserves and, most significantly, its short-term
debt. In January 1995, Mexico faced the need to pay out about $10
billion for tesobonos coming due in the following 3 months unless it
could convince bondholders to buy new Mexican government debt
securities. As investors became aware that Mexico had only about $6
billion in foreign reserves in early January 1995, they were
increasingly concerned about the possibility of default and sought to
redeem their investments.
A senior Finance ministry official explained that during the crisis,
Mexico could not reissue its internal debt at any price. Bondholders
were numerous, unlike the situation when a few large banks held a
much larger proportion of Mexican external debt in 1982.\17 The
market was more volatile in January and February of 1995. This
official added that perception became reality when investors feared
they could not get their money back.
Key Mexican financial indicators revealed that investors were leaving
Mexican markets after the devaluation of the peso. For example, the
Bolsa index declined sharply in the wake of the devaluation. From
December 20, 1994, to February 27, 1995, the Bolsa index fell 36.3
percent in nominal peso terms. The index began in 1995 at 2,376, and
then dropped by the end of January to 2,094. As Mexico's financial
situation continued to deteriorate, the market index fell throughout
February, reaching a low of 1,448 on February 27 (see fig. 2.8).
According to IMF, overall net capital outflows totaled more than
$11.5 billion in the first quarter of 1995.
--------------------
\17 In 1982, Mexico's external debt was concentrated in the hands of
a small number of large foreign banks. Concerned about their
significant exposure, these banks had a stake in restructuring
Mexico's external debt. However, in 1995 Mexican internal debt was
dispersed among numerous private investors and investment funds that
had invested in Mexican securities. Mexican authorities had little
leverage over these investors.
THE GOVERNMENTS OF MEXICO
AND THE UNITED STATES TOOK
REMEDIAL ACTION
-------------------------------------------------------- Chapter 2:6.2
During the period from December 22, 1994, to January 12, 1995, a
variety of actions were taken to deal with Mexico's financial
problems. On December 28, Finance Minister Jaime Serra was replaced
by Guillermo Ortiz, previously Secretary of Communications and
Transport. On December 30, 1994, Mexico's swap line was increased.
A short-term Bank for International Settlements (BIS) facility was
arranged for the Bank of Mexico. An announcement was made of an
effort to raise funds from a group of international commercial banks.
Mexico announced that it would seek an IMF stand-by arrangement, and
efforts were made to line up loans and disbursements from
multilateral development banks.
On January 2, 1995, President Zedillo announced an emergency economic
plan that was designed to reassure the international investment
community that Mexico had its economic affairs back in order. The
plan aimed to avoid an inflationary spiral, reestablish investor
confidence, and stimulate structural reforms to enhance economic
growth. On the domestic front, the plan laid out a strict policy on
wage increases of only 7 percent, cuts in public spending equal to
1.3 percent of GDP, a reduction of development bank lending by 2
percent of GDP, and some expansion of privatization. The current
account deficit for 1995 was projected to be $14 billion or 4.2
percent of GDP. This Pacto was supported by an exchange
stabilization fund of $18 billion in short-term credit lines provided
by foreign governments, led by Treasury and Federal Reserve in the
United States, in cooperation with the Bank of Canada, and other
central banks acting through BIS and in cooperation with a small
group of international banks. The omission of wider reforms and
doubts about its wage pact led to an unfavorable reaction from
financial markets.
Also on January 2, 1995, Treasury and the Federal Reserve announced
supplemental swap facilities for Mexico. The existing $6 billion
swap agreement between the United States and Mexico was supplemented
with an additional $3 billion short-term facility, with Treasury and
the Federal Reserve each participating up to $1.5 billion. That is,
the U.S. swap line with Mexico was increased to $9 billion. A
Treasury official stated that the decision to increase the swap line
with Mexico was based on the importance of the U.S.-Mexican economic
relationship, the substantial economic reforms that Mexico has
undertaken in recent years, and the strong program just announced by
President Zedillo. Also, the existing Canadian $1 billion swap
facility between the Bank of Canada and the Bank of Mexico was
supplemented by an additional Canadian $500 million. The action was
taken in the context of the North American Financial Group.
On January 9, 1995, the Bank of Mexico announced a new policy on
regular announcements of its foreign exchange reserves. Also, on
January 9, the Bank of Mexico announced drawings on the North
American Financial Agreement swap facilities including $500 million
from U.S. monetary authorities and Canadian $83 million from the
Bank of Canada. In addition, the Bank of Mexico announced plans to
use $16 billion of credit to help the nation's banks and companies
with dollar-denominated liabilities.
On January 9, both U.S. and Mexican monetary authorities intervened
in foreign exchange markets to stabilize the value of the peso. The
Federal Reserve Bank of New York announced that, consistent with the
efforts of U.S. monetary authorities to assist Mexico in responding
to recent financial developments, it was intervening in the foreign
exchange market at the request of, and for the account of, the Bank
of Mexico, purchasing pesos in exchange for dollars. Mexico also
intervened in the New York and Mexican foreign exchange markets for
the first time since the floating of the peso on December 22.
U.S. GOVERNMENT AND IMF AWARENESS
OF MEXICO'S FINANCIAL SITUATION,
AND ADVICE PROVIDED TO MEXICAN
GOVERNMENT
============================================================ Chapter 3
Our document review and interviews with Treasury, State Department,
and Federal Reserve officials showed that senior U.S. officials were
kept apprised of economic and political developments in Mexico during
1994. They exchanged views with Mexican officials on multiple
occasions on the appropriateness of Mexico's exchange rate policy.
Before the Colosio assassination in March, officials at Treasury and
State Departments and at the Federal Reserve had some concerns that
Mexico was vulnerable to speculative attacks on the peso and that
Mexico's large current account deficit and its exchange rate policy
might not be sustainable. One month after the Colosio assassination,
the United States and Canada established permanent, enlarged currency
swap facilities that could be used to help Mexico defend the peso
from any future speculative attacks. Financial markets' reaction to
the Colosio assassination, documents showed, also increased Treasury,
State, and Federal Reserve officials' concerns about the viability of
Mexico's exchange rate policy.
Our review showed that by early summer 1994, staff in the Federal
Reserve had concluded that the peso probably was overvalued. But
they remained unsure about whether and, if so, when and in what
manner, financial markets would force Mexico to react. Federal
Reserve, Treasury, and State Department documents from this period
showed that their analysts generally believed that Mexican financial
markets would remain volatile until the Mexican presidential election
in August, but that after the election, foreign investment inflows to
Mexico might recommence and pressure on the peso might abate. In
July 1994, U.S. and Mexican officials reached an oral understanding
that Mexico would devalue the peso after the election if continued
pressure on the peso led to a further drawdown of Mexico's foreign
currency reserves.
After the election, when foreign investment flows to Mexico did not
resume in significant amounts and Mexico's foreign currency reserve
levels remained at pre-election levels, concern grew within the
Treasury and State Departments and the Federal Reserve over the
extent of the peso's overvaluation and the sustainability of Mexico's
exchange rate policy. Treasury and Federal Reserve officials told us
that they were concerned about whether Mexico's exchange rate policy
was consistent with other Mexican macroeconomic policies. During
October and November, high-level U.S. officials cautioned Mexican
officials that the peso seemed overvalued and indicated that it was
risky to continue the existing exchange rate policy. Treasury
Department and Federal Reserve analyses provided to us for the late
August through December 20 period did not foresee nor judge likely
that a forced devaluation would require a major financial assistance
package from the United States.
There were several reasons why senior Treasury, State, and Federal
Reserve officials did not provide stronger advice to Mexican
authorities during 1994. First, the evidence and analyses that the
peso needed to be devalued were not sufficiently compelling for them
to provide more adamant advice to devalue. Also, as they testified,
U.S. officials (1) were sensitive to the fact that decisions on
whether and how to change Mexican economic policies ultimately rested
with Mexico; (2) had confidence in the competence of Mexican economic
management; and (3) believed that if Mexico were forced by financial
markets to devalue the peso, the consequences would not be as severe
for Mexico and for other developing countries' financial markets as
they turned out to be. U.S. officials did not publicly discuss
their concerns over Mexico's financial situation in 1994 out of
concern about provoking an immediate flight of capital from Mexico.
The International Monetary Fund (IMF) completed an annual review of
Mexico's foreign exchange policy and economic policies in February
1994. The review did not identify problems with Mexico's exchange
rate policy. Further, Treasury and IMF officials told us that IMF
did not keep close watch on developments in Mexico during 1994, did
not foresee the crisis, and did not see a compelling case for Mexico
to alter its exchange rate policy before the December 20, 1994,
devaluation.
U.S. OFFICIALS MONITORED
MEXICAN SITUATION THROUGHOUT
1994
---------------------------------------------------------- Chapter 3:1
The documents we reviewed showed that throughout 1994, officials in
several federal agencies monitored economic and political
developments in Mexico, and senior officials were kept informed about
developments thought to be important. The Treasury Department's
financial attach� at the U.S. embassy in Mexico City provided
biweekly reports on financial developments in Mexico, as well as
other information on Mexico's economic situation, to Treasury
officials in Washington, D.C. These officials evaluated developments
in Mexico, using the information supplied by the financial attach�
and other sources, and reported to the Under Secretary of the
Treasury for International Affairs.
Officials in the Federal Reserve also monitored the Mexican
situation. Analysts at the Federal Reserve Bank of New York and at
the Federal Reserve Board in Washington, D.C., tracked events in
Mexican financial markets and informed members of the Federal
Reserve's Federal Open Market Committee (FOMC)\1 of important
developments. The State Department followed events in Mexico from
the U.S. embassy and consulates in Mexico, and from Washington, D.C.
U.S. embassy staff in Mexico City provided, among other information
and analyses, weekly reports on financial developments in Mexico to
State Department headquarters. CIA also monitored events in Mexico.
U.S. and Mexican authorities maintained contact throughout 1994.
These contacts provided opportunities for U.S. and Mexican officials
to exchange views on Mexico's economic situation and policies, both
formally and informally. For example, U.S. and Mexican officials
met at the annual meeting of the U.S.-Mexican Binational Commission
in May 1994 and at the annual meeting of the World Bank and IMF in
Madrid, Spain, in October 1994. Also, the U.S. Treasury Secretary
and other high-level U.S. officials visited Mexico on several
occasions in 1994. Further, senior Mexican officials travelled to
the United States to meet with senior administration officials,
including the Secretary of the Treasury and the Chairman of the
Federal Reserve. Also, beginning in June 1994, Federal Reserve,
Mexican, and Canadian central bank officials held regular telephone
discussions on developments in financial markets in connection with
the establishment of the North American Financial Group.
For the following discussion of the events of 1994, we divided the
year into 2 periods based on significant events. The first
period--January 1 to July 31--included the assassination of Colosio
in March, Mexico's reaction to falling investor confidence after the
assassination, and preparation for the August presidential election.
The second period--August 1 through December 22--included the
election on August 21, the growing overvaluation of the peso through
the fall, and the devaluation of the peso on December 20.
--------------------
\1 FOMC sets monetary policy for the Federal Reserve. The Committee
comprises the seven Federal Reserve governors and the presidents of
Federal Reserve banks, with five of the presidents serving as voting
members at one time.
JANUARY THROUGH JULY 1994:
U.S. OFFICIALS' CONCERNS OVER
MEXICO'S ECONOMIC SITUATION
GREW AS EVENTS UNFOLDED
---------------------------------------------------------- Chapter 3:2
JANUARY 1, 1994, THROUGH
MARCH 23, 1994: U.S.
OFFICIALS SOMEWHAT CONCERNED
ABOUT MEXICAN MACROECONOMIC
POLICIES
-------------------------------------------------------- Chapter 3:2.1
Our review of Treasury and State Department and Federal Reserve
documents and interviews with their officials indicated that before
the March 23, 1994, assassination of PRI presidential candidate
Colosio, U.S. authorities had some concerns over the sustainability
of Mexico's macroeconomic and exchange rate policies during the short
run. Documents and interviews with U.S. officials showed that they
were aware that Mexico was experiencing a large current account
deficit financed mostly by short-term portfolio capital that was
vulnerable to a sudden reversal of investor confidence in Mexico.
U.S. officials also were concerned that declining Mexican interest
rates, coupled with rising U.S. interest rates and investment
opportunities in other emerging markets, could lead to capital
outflows from Mexico and pressure on the peso. In addition, one
Treasury memorandum expressed concern that Mexico's inflation rate
had remained above that of the United States for several years and
that this had caused the peso to appreciate in relation to the dollar
in inflation-adjusted terms. A senior Treasury official advised us
that Treasury believed Mexico's economy was fundamentally sound in
the sense that Mexico had implemented many macroeconomic reforms such
as balancing its fiscal account and carrying out structural reforms
that made its economy more competitive. However, he said, even in
February 1994 he felt that Mexico's exchange rate was "on the high
side" because of Mexico's inflation differential, relative to the
United States, and its large trade deficit. A Federal Reserve
official told us that the Federal Reserve had become concerned about
the size of Mexico's current account deficit and its exchange rate
policy even before 1994.
However, it appears that these concerns were outweighed by a number
of other considerations that pointed to a more optimistic view of
Mexico's near-term economic prospects. Perhaps foremost was that
these U.S. government officials believed that Mexico had sound
economic fundamentals and appeared to have laid an adequate
foundation for economic growth in the long term, due in large part to
the major economic reforms that Mexico had implemented in the
previous decade. Further, in the period between the approval of
NAFTA and the Colosio assassination, Mexico was continuing to attract
large amounts of foreign capital, and the Bank of Mexico held
substantial foreign currency reserves. Also, the peso was trading in
the strongest region of its trading band. A February 10, 1994,
Treasury memorandum informed the Secretary of the Treasury that the
peso could lose 8 percent of its value and still remain within the
band.
Still, documents showed that U.S. officials recognized that adverse
political events could again shake investor confidence in Mexico.
For example, a March 21, 1994, Federal Reserve staff paper noted that
political events, such as the Chiapas uprising in January 1994 and
uncertainty over the outcome of the August 1994 Mexican presidential
election, had "unnerved" Mexican foreign exchange and cetes markets.
And, the paper said that underlying economic conditions--not just
political events--were consistent with a weakened peso. However, the
paper listed several factors that it said might "obviate the need for
a peso depreciation in the near-term." These factors, according to
the paper, included Mexico's substantial foreign currency reserve
levels, the Mexican government's pledge to maintain a stable peso
exchange rate, and the likelihood that foreign capital inflows would
continue at high levels in 1994.
U.S. officials, although somewhat concerned at this time that the
peso was vulnerable, appear to have believed that Mexican authorities
could manage any future such crises. An event in 1993 had lent
credence to this view. In November 1993, foreign portfolio flows
into Mexico had reversed suddenly due to uncertainty about whether
the U.S. Congress would approve NAFTA. Intense speculative pressure
on the Mexican peso led to a sudden drawdown of Mexico's foreign
currency reserves. According to a State Department document, the
Mexican government responded to the pressure by allowing the peso to
depreciate and, as chapter 1 discussed, by issuing more tesobonos.
The U.S. and other governments reacted by arranging a temporary
short-term, $12-billion swap facility for Mexico through the Bank for
International Settlements (BIS). This facility was never used.
After Congress approved NAFTA, foreign investment flows quickly
resumed, and the peso appreciated and then stabilized. Several
Treasury and State Department documents from January and February
1994 cited these events in discussions of Mexico's financial
situation.
Further, in December 1993, the Secretary of the Treasury had agreed
to consider a Mexican request to enlarge substantially, from $1
billion to about $5 billion, a permanent currency swap facility that
Mexico maintained with the United States.\2 According to a Federal
Reserve official, the enlarged swap facility would allow Mexico to
maintain orderly exchange rate markets, even during times of intense
speculative pressure on the peso caused by financial markets'
reactions to political events. U.S. officials had explained to
Mexican officials that the facility was to be used to respond to
disorderly market conditions and that the United States would not
allow an expanded swap facility to be used to support an overvalued
peso.
Because U.S. government officials did not perceive a high risk of
financial difficulty in Mexico in the near term, they were not
adamant in voicing their concerns over Mexico's immediate economic
prospects and policies to Mexican authorities before the Colosio
assassination. During Mexico's annual consultation with IMF in
February 1994, the U.S. government raised some questions about the
size of Mexico's current account deficit and the lack of GDP growth
in Mexico. Yet the U.S. administration did not dispute the thrust
of the IMF's staff report, which was supportive of Mexico's ability
to manage the situation.
Also in February 1994, the U.S. Treasury Secretary and other senior
Treasury officials visited Mexico City. The Treasury Secretary met
with Mexico's President, Finance Minister, and other senior Mexican
officials. Briefing materials prepared by Treasury staff for the
Secretary's visit did not advise the Treasury Secretary to issue any
cautions to Mexican officials over their exchange rate or
macroeconomic policies. Negotiations over expanding Mexico's
permanent swap facility with the United States continued during the
Treasury officials' February 1994 visit to Mexico.
--------------------
\2 Expanding an existing currency swap facility between Canada and
Mexico also was part of these discussions.
MARCH 23, 1994, THROUGH MAY
1994: MARKETS REACT TO
COLOSIO ASSASSINATION, AND
EXPANDED SWAP FACILITY
CREATED FOR MEXICO
-------------------------------------------------------- Chapter 3:2.2
Treasury officials initially hoped that markets would react calmly to
the assassination. A March 24, 1994, Treasury Department memorandum
reported no panic in Mexican financial markets and a "broad view"
that a Mexican statement reconfirming the existing exchange rate band
probably would be enough to keep exchange market pressure in line.
The memorandum's author reported telling market participants that
Mexico's high foreign reserve levels "did not make a run on the peso
very credible." A second March 24 memorandum attached an analysis by
an investment bank. The analysis stated that "if Mexico's central
bank declares its intention to sell dollars as necessary to defend
the peso . . . the band can be defended without much trouble." A
March 25 staff memorandum to the Secretary of the Treasury said that
market commentary was "generally positive on the prospects for next
week in the absence of a further major crisis."
Immediately after the assassination, both Mexican authorities and the
U.S. administration took quick action to try to calm financial
markets. As discussed in chapter 2, Mexican authorities allowed the
peso to move to the top of its foreign exchange band, raised Mexican
interest rates substantially to attract more investment, and offered
investors more tesobonos. The U.S. Treasury and Federal Reserve
created and, on March 24, announced the existence of a temporary,
enlarged, $6-billion swap facility for Mexico. The facility
consisted of $3 billion in a swap arrangement with the Exchange
Stabilization Fund (ESF) and $3 billion in a swap arrangement with
the Federal Reserve. Also, President Clinton and other senior U.S.
officials made public statements immediately after the assassination
affirming U.S. confidence in Mexico's political and economic
stability. A March 25 cable from the U.S. embassy in Mexico City to
State Department headquarters credited the announcement of the
$6-billion swap facility as being "key" to reassuring financial
markets. Also, on March 24, the Organization for Economic
Cooperation and Development (OECD) announced that it would accept
Mexico as a member.
Despite these events, however, investor confidence in Mexico
continued to lag in April, and the Bank of Mexico continued to expend
large amounts of foreign currency reserves. An April 11 Treasury
memorandum reported rumors that Mexican authorities had spent $5
billion intervening on behalf of the peso since the assassination.
An April 15 cable from the U.S. embassy in Mexico City reported that
a Mexican trade association had estimated that between $5.2 billion
and $5.7 billion had left Mexico from March 23 to the week of April
11. In fact, by April 20, Mexico held $18.1 billion of foreign
currency reserves, a decline of about $10 billion since the
assassination.
On April 26, 1994, U.S., Mexican, and Canadian authorities finished
negotiations to establish a permanent, enlarged currency swap
facility, subject to annual review. The permanent trilateral
facility between the three countries was created and announced in
conjunction with the establishment of the North American Financial
Group, a new trilateral consultation mechanism. The swap facility
had three components: creation of a $6-billion swap facility between
Mexico and the United States, with the Federal Reserve and Treasury
each participating up to $3 billion; expansion of an existing swap
facility between the Canadian and Mexican central banks to CAN$1
billion, and renewal of a preexisting $2-billion swap arrangement
between the U.S. Federal Reserve and Canada's central bank. The
stated purpose of the swap facilities was to help ensure orderly
foreign exchange markets. A senior Federal Reserve official told us
that one purpose of the U.S.-Mexican swap facility was to help to
reassure financial markets that in the event of a speculative attack
on the peso not justified by Mexican economic fundamentals, Mexico
would be able to weather the attack without devaluing. Similarly, a
Treasury official told us that one purpose of the swap facility was
to allow Mexico to weather temporary shocks, including those caused
by political events, that were not justified by Mexican economic
fundamentals. A second purpose, he said, was to allow time for any
Mexican policy adjustments to take effect; i.e., to help Mexico ride
out any short-term market disruptions caused by policy changes.
Beginning in late April, Mexican financial markets stabilized. The
peso appreciated yet remained comfortably within its trading band.
The Bank of Mexico ceased intervening on behalf of the peso on April
22, and foreign currency reserves stabilized at about $16 billion to
$17 billion through the end of June 1994. Mexico did not draw funds
from the swap facility at that time.
The financial crisis that followed the Colosio assassination
heightened Treasury officials' concerns about the state of Mexico's
economy and the continued viability of Mexico's macroeconomic
policies. For example, a March 29, 1994, Treasury staff memorandum
concluded that higher U.S. interest rates would have a greater
effect on Mexican markets than the current political uncertainty.
The memorandum noted that the Mexican government "will increasingly
face a dilemma of either (1) losing out on capital inflows because of
too small an interest premium or (2) worsening the fiscal deficit due
to higher interest costs at a time of expansion in support of
electoral politics."
During April, several Federal Reserve and State Department analyses
expressed worries about Mexico's financial situation. An April 7
cable from the U.S. embassy in Mexico City informed the State
Department in Washington, D.C., that for the first time since
November 10, 1993, the Mexican government had been unable to place
all the bonds it had offered at auction. As noted in chapter 2, in
mid-April 1994, Treasury officials circulated a paper by economists
Dornbusch and Werner. The paper concluded that the Mexican peso was
overvalued by about 20 percent and that Mexico should devalue its
currency. An April 22, 1994, analysis of the paper by a Treasury
official agreed that the peso was overvalued by around 20 percent and
concluded that the analysis was "mainstream for this sort of analysis
. . . [and] quite good." However, Treasury officials also were
aware of an analysis of the Dornbusch/Werner paper that, while
concurring that the peso was overvalued, argued that the case for a
Mexican devaluation at that time was "weak."
A Treasury official told us that by late April, Treasury's concerns
over underlying problems with Mexico's economic situation "had grown
another notch." Still, he said, Treasury did not want to see Mexico
"derailed" by political events, such as the Colosio assassination at
the end of March, which was the big event that had triggered the
start of large capital outflows from Mexico. The Treasury hoped that
Mexico could get beyond the assassination, which was viewed as a
transitory political shock.
In discussions with us, Mexican officials described how they viewed
the events of late March and April 1994. They told us that since
other Mexican economic indicators were positive following Colosio's
assassination, the Finance ministry and the Bank of Mexico expected
that the pressure on the peso would be temporary and that foreign
investment would return as it had after the November 1993 NAFTA vote.
The Mexican officials also asserted that the economic literature at
the time held that Mexican interest rates were too high and the
Mexican business community believed monetary policy was too tight.
In addition, they said that the Mexican government decided at this
time to absorb investors' foreign exchange risk by offering more
tesobonos. They noted that the government preferred doing this at a
time when financial risks may have been perceived by investors to be
greater than the Mexican government thought was warranted. Finally,
they said that the peso had lost about 10 percent of its value within
its trading band during April and May and that the government's
action also addressed investor concerns.
On May 8, a senior U.S. Treasury official visited Mexico City and
met with the Mexican Finance Minister and the President of the Bank
of Mexico. Briefing materials for the U.S. official noted that
"Mexico's dependency on the financing of its large current account
deficit from largely volatile foreign portfolio investment remains a
serious problem." The memorandum predicted that Mexico's current
account deficit in 1994 would remain at the 1993 level of 5.9 percent
of Mexico's GDP and that Mexico's GDP would grow at a 2-percent rate
in inflation-adjusted terms for all of 1994. According to the
memorandum, continued capital outflows could hamper financing of
Mexico's current account deficit and further drive up Mexican
interest rates.
The briefing materials also said that the meeting would provide an
opportunity for the Treasury official to "sound out" his Mexican
counterpart on recent political and economic developments in Mexico.
The briefing materials noted that Mexico probably had lost $10
billion in reserves since the Colosio assassination, but that
financial market volatility recently had moderated somewhat. The
materials added that "for the moment [Mexican] government efforts to
halt capital flight by hiking interest rates appears [sic] to be
working." The memorandum suggested that the Treasury official raise
several concerns with Mexican officials involving recent volatility
in Mexican politics and financial markets. The U.S. official was
urged to ask for an assessment of the situation and a discussion of
what actions Mexico would take if world interest rates continued to
rise. Also, the memorandum suggested asking for an assessment of the
"prospects of further political incidents which might further
destabilize Mexico's financial markets."
Documents that we reviewed from late May showed both optimism and
pessimism about Mexico's economic prospects for the rest of 1994. A
May 28 cable from the U.S. embassy in Mexico City noted that the
peso and Mexican financial markets recently had shown more stability.
Yet, the cable predicted that markets were likely to be somewhat
volatile until the August presidential election, but that the
resumption of economic growth in the first quarter of the year,
controlled inflation, growing exports, and other factors would
provide a "sound environment for long-term growth in corporate
earnings." A May 25 U.S. embassy cable reported that most Mexican
private sector analysts believed that a Mexican economic recovery
probably would occur after the August presidential election. But it
also noted that further increases in U.S. interest rates could
stymie the recovery, and it reported Mexican concerns over further
political instability.
SUMMER 1994: U.S.
OFFICIALS MORE CONVINCED
THAT PESO OVERVALUED
-------------------------------------------------------- Chapter 3:2.3
A Federal Reserve paper from July that provided detailed analyses of
Mexican exchange rate policies concluded that the peso was overvalued
by 5 to 15 percent. However, there does not appear to have been a
consensus among U.S. officials in the summer of 1994 that the peso
was overvalued, and, if so, on when financial markets might force
Mexico to adjust the peso's value, or the type of adjustment Mexico
should try to make. For example, a June 23 Federal Reserve
electronic mail message from a senior Federal Reserve official to a
staff member indicated that the official was unsure what actions
Mexico should take to correct its exchange rate policy, or when it
should act. The message stated that "I think we need once again to
examine Mexico's exchange rate policy," and it asked, "What is in
Mexico's medium-term interest: to try to hold the current band or to
permit some adjustment; if the latter, how much?"
A July 17, 1994, Federal Reserve memorandum that reported on a staff
member's visit to Mexico stated that there was "general agreement
that any change in the exchange rate before the election would be a
political disaster." Yet, the memorandum also stated that opinion in
Mexico was divided about the viability of the present exchange rate
policy in the "medium term" and did not take a position on whether
the peso was overvalued. A senior Federal Reserve official told us
that by July 1994, he believed that the probability that Mexico would
have to adjust its exchange rate policy was "greater than 50
percent." He said he believed that Mexico had two options at that
time: a devaluation of 10 percent combined with an increase in the
peso's crawl rate, or a doubling of the rate of the exchange rate
crawl.
Documents show that during June and July 1994, Treasury, State, and
Federal Reserve analysts believed that Mexican financial markets
would remain volatile until the August 21, 1994, Mexican presidential
election but would then settle down, and foreign investment inflows
and Mexican economic growth would resume. For example, in June 3 and
June 17 cables, an official at the U.S. embassy in Mexico City
predicted that Mexican financial markets would remain "nervous and
speculative" until the August election and that foreign investment,
both direct and portfolio, would "pick up" after the election. In a
June 6 memorandum, a Treasury Department official in Mexico City
reported saying in a public speech in Mexico that Mexican economic
growth would resume late in the year, following the August election
and clarification by the Mexican government of its economic policies.
A July 15 Treasury staff memorandum to a senior Treasury official
said that "financial markets continue to be strongly influenced by
concerns about the outcome of this year's presidential election." In
fact, there was substantial selling of the peso between June 21 and
July 22, during which Mexico's foreign exchange reserves were drawn
down by nearly $3 billion, from $17 billion to $14.2 billion.
JULY UNDERSTANDING REACHED
THAT MEXICO WOULD ADJUST ITS
EXCHANGE RATE SYSTEM AFTER
THE AUGUST ELECTION IF
CONDITIONS WARRANTED
-------------------------------------------------------- Chapter 3:2.4
According to a Federal Reserve document, in early July 1994, Mexican
officials asked the Federal Reserve and Treasury to explore with
other Group of Ten (G-10)\3 central banks whether there would be any
interest in reviving a contingency, short-term, financial support
facility. According to the document, Mexican officials were not
convinced that a devaluation would be necessary but saw the proposed
facility as possibly contributing to market confidence in Mexico.
The document stated that it was difficult to determine at that time
whether a substantial change in Mexico's exchange rate policy was
warranted on economic grounds and that a reasonable case could be
made either way. Nonetheless, Federal Reserve officials were
concerned about the viability of the peso exchange rate policy if
pressure continued after the August elections and were even worried
that Mexico might have to alter its policy before the election. One
G-10 central bank official had also raised concerns about the
viability of the peso after the election, the Federal Reserve
document said.
According to Federal Reserve documents and U.S. and Mexican
officials with whom we spoke, discussions were held in mid-July among
the U.S. Secretary of the Treasury, the Chairman of the Federal
Reserve, Mexico's Finance Minister, and the Governor of the Bank of
Mexico about the proposed swap facility. According to the documents,
the Federal Reserve Board Chairman advised the Mexican officials that
the United States needed some type of understanding that Mexico would
adjust its exchange rate policy after the election in the event that
pressure on the peso continued. A few days later, another high-level
Federal Reserve official spoke with a high-level official of the Bank
of Mexico. According to a Federal Reserve document and interviews
with Federal Reserve and Treasury officials, the bank official
assured the Federal Reserve official that if pressure on the peso
exchange rate continued after the election, Mexican authorities fully
intended to adjust their exchange rate policy within a reasonably
short period, for example, by the end of September 1994. The Mexican
official indicated that he expected that pressure might ease after
the election but that if it continued, there would be no way to avoid
a revision in Mexico's exchange rate policy. Subsequently, U.S.
officials contacted other G-10 governors about Mexico's proposal and
got a positive response to establishing a swap facility.
In August, a $12-billion contingency swap facility was established,
with the U.S. monetary authorities agreeing to provide up to half of
the amount and BIS, backed by other countries' central banks, the
rest. The U.S. portion of the facility was to consist of the
$6-billion swap facility created in April 1994. If Mexico chose to
announce the new, $12-billion facility, it would be able to draw upon
the arrangement until September 30 for a period of 90 days. All
drawings would have to be repaid by December 30. U.S. officials
told us that the arrangement was designed in part to allow Mexico to
get through the August presidential election.
--------------------
\3 The Group of Ten are industrialized countries that coordinate
monetary and fiscal policies in an attempt to create a more stable
world economic system. The group consists of 11 member countries:
Belgium, Canada, France, Germany, Italy, Japan, The Netherlands,
Sweden, Switzerland, the United Kingdom, and the United States.
AUGUST THROUGH DECEMBER 1994:
U.S. OFFICIALS ADVISED MEXICO
THAT EXCHANGE RATE WAS
OVERVALUED, INDICATING THAT
ACTION WAS NEEDED
---------------------------------------------------------- Chapter 3:3
Uncertainty about the extent to which the Mexican peso was overvalued
and about whether and, if so, when Mexico would need to adjust either
its macroeconomic policies or its exchange rate policy continued from
August through mid-December. Between October and November 20, when
Mexican officials met and decided not to devalue, high-level U.S.
officials advised Mexican officials that their exchange rate policy
was risky and encouraged Mexico to make adjustments to the policy.
U.S. officials were concerned because the peso was trading close to
the top of the exchange rate band, leaving little room to accommodate
additional pressures. In addition, political instability continued,
and financial flows had not returned to Mexico. Following November
20, U.S. agencies continued to monitor the peso's deteriorating
condition. Analyses provided to us for August through December 20
indicate that U.S. officials did not foresee or judge likely that a
forced devaluation would provoke a financial crisis of such magnitude
as to require a major financial assistance package from the United
States.
AUGUST 1 TO NOVEMBER 20:
U.S. OFFICIALS ADVISED
EXCHANGE RATE WAS OVERVALUED
-------------------------------------------------------- Chapter 3:3.1
By mid-August 1994, financial markets became more optimistic about
the likely outcome of the August 21 Mexican election. Investment
outflows from Mexico ceased, and pressure on the peso abated. An
August 13 report from the U.S. embassy in Mexico City observed that
financial markets were showing optimism over the upcoming election.
On August 16, 1994, the Mexican government announced that Mexico's
GDP had grown at an annual rate of 3.8 percent during the second
quarter of 1994 compared to a year earlier. Treasury Department and
Federal Reserve memorandums noted that this growth rate was higher
than expected. The memorandums attributed the August surge in
investor confidence in Mexico in part to this announcement, although
one of the memorandums noted that there was some skepticism about the
figure. On August 19, 1994, 2 days before the election, a Federal
Reserve memorandum noted that the Mexican peso had ended trading that
day at its highest point since early June 1994.
Nonetheless, an August 12 Federal Reserve document said that
Dornbusch's assertion that the peso was overvalued by 20 percent "is
possibly well grounded by economic fundamentals." On the other hand,
a Federal Reserve staff analysis of August 17 said that it was not
clear if the peso was overvalued and, if it was, by how much.
However, the analysis estimated that the peso was probably overvalued
by about 10 percent and cited a range of 5 to 15 percent. The
analysis suggested that Mexico would eventually have to devalue due
to inflation differentials between the United States and Mexico and
the real appreciation of the peso. According to the analysis, the
timing could be either over the "short or medium term."
A Federal Reserve analysis of August 19 examined differentials
between Mexican and U.S. interest rates to estimate how financial
markets were calculating the implied probability of a peso
devaluation. The analysis concluded that financial markets perceived
only a 6-percent chance of a 20-percent devaluation during the next 3
months and a 15-percent chance during the next year.
A September 23 Federal Reserve analysis reported that about $40
billion in tesobonos were outstanding, with about half of them held
by the Bank of Mexico. According to the analysis, $685 million worth
of tesobonos had matured 2 weeks previously, causing significant
pressure on the peso. The paper noted that another $2 billion in
tesobonos would mature on September 29 and speculated about whether
Mexican authorities would announce a new Pacto either before or after
that date. In fact, as discussed in chapter 2, a new Pacto was
announced on September 24 that did not adjust the existing exchange
rate policy.
A September 28 Federal Reserve analysis discussed the peso's
valuation in terms of the new Pacto. The analysis concluded that
President-elect Zedillo's administration had chosen a path of
gradual, long-term adjustment rather than immediate adjustment to
address Mexico's extremely high current account deficit. (For
example, the agreement allowed for only a 6-percent nominal
depreciation of the peso through the end of 1995.) The analysis
characterized the Pacto's policies as risky on the grounds that they
would not produce a reduction in the current account deficit in 1995.
The paper characterized the government's inflation target of 4
percent as very ambitious and concluded that the exchange rate policy
did not leave the authorities much room to maneuver in the event of
renewed pressure on the peso. However, the paper said, if foreign
investors maintained confidence in Mexico, the program could allow
Mexico to depreciate the peso gradually and reduce its current
account deficit over the next several years.
On September 29, a Federal Reserve staff paper noted that the peso
was somewhat overvalued--citing estimates of about 10 percent--but
concluded that the government would probably be able to maintain the
peso within its band over the next year and without the additional
large interest rate increases such as those that took place earlier
in 1994. However, the paper warned that the policies needed to
reduce inflation further probably would continue to depress economic
growth in the near term. In addition, the paper said, the peso would
probably remain vulnerable to political shocks such as had been seen
earlier in the year. Failure to adjust the peso during 1995 and
continued growth in the current account deficit, it said, might
create the need for a larger and possibly more destablizing
adjustment in 1995.
By mid- to late October, both the Federal Reserve and Treasury had
become quite concerned about the risks and costs of Mexico's trying
to defend its exchange rate policy. The peso was trading close to
the top of the exchange rate band, leaving little room for further
depreciation within the band if pressure on the currency continued.
(See fig. 3.1, which shows how the peso traded very close to the top
of the band for much of 1994.)
Figure 3.1: Mexico's Exchange
Rate Band Intervention Points
and Observed Values, January 1,
1994, to December 19, 1994
(See figure in printed
edition.)
Note: The shaded area shows the exchange rate band that Mexico
maintained through December 19. The upper sloping line of the shaded
area represents the ceiling of the band, which was adjusted over
time. The Mexican central bank allowed the peso to depreciate
gradually at a rate of $0.0004 per day. As the peso/dollar exchange
rate approached the ceiling, the central bank would intervene in
foreign exchange markets by buying pesos to keep the peso from
further depreciating in value. The line at the bottom of the shaded
area represents the floor of the band, which was fixed at 3.0512
pesos/dollar. As the peso/dollar exchange rate approached the floor,
Mexico's central bank would sell pesos to keep the peso from further
appreciating in value relative to the dollar. On December 20, Mexico
announced a 15-percent devaluation of the existing ceiling of the
exchange rate band, to 4.0016 pesos/dollar. However, Mexico was
unable to defend the band for long. On December 22, it allowed the
peso to float. By the end of the year, the peso was valued at 5.325
pesos per dollar.
Source: Bank of Mexico.
On October 20, 1994, high-level Federal Reserve officials met with an
official of Mexico's president-elect transition team. According to a
written account of the meeting, the Federal Reserve officials noted
that Mexico's credibility in world financial markets had increased
tremendously, improving Mexico's ability to achieve foreign
financing. However, they cautioned that Mexico's substantial
economic progress could be set back by an exchange rate policy that
made Mexico vulnerable to a crisis. They suggested that widening or
shifting the band might be one way of providing additional
flexibility. In response, the Mexican official advised them that the
transition team had considered adjusting the exchange rate but had
decided against making any changes in the near future. The team
intended, he said, to revisit the issue in 1995, once the new
government was in place and after the team saw how the economy was
evolving. The Federal Reserve officials indicated that that was a
risky strategy. They agreed that it was not clear how overvalued the
peso was but noted that there was considerable uncertainty in
financial markets about the value of the peso. Greater leeway was
needed, they said, to allow the peso to absorb possible future
financial shocks. If more room were available for the peso to move
up or down, they said, the situation would allow for two-way risks
for speculators against the peso. Federal Reserve officials told us
that they conveyed a similar message at about the same time to
Mexico's Finance Minister.
On October 21, 1994, a Treasury staff memorandum to a senior Treasury
official noted that the Bank of Mexico had publicly announced its
international reserve levels as of October 14 at $17.2 billion.
According to the memorandum, the figure was above market expectations
of $15 billion to $16 billion and had made a positive impact on
trading on the day of the announcement. However, the memorandum
noted that the peso had fallen to a record low on October 17,
apparently as the result of increased tension in Chiapas. On October
25, a staff memorandum to the Treasury Secretary advised that the
peso had fallen in value and was just "a hair away" from the margin
at which the Bank of Mexico normally intervenes in financial markets
by selling dollars. According to the memorandum, the fall was
attributed to several events, including a recent rise in U.S.
interest rates, the maturation of a large number of tesobonos, and a
TELMEX (Mexico's third largest company) announcement of disappointing
third-quarter earnings. The memorandum concluded that the peso
appeared to remain quite vulnerable.
According to a briefing memorandum prepared for an October 27 meeting
of the Secretary of the Treasury with Mexico's Finance Minister,
Treasury was concerned that Mexico's exchange rate system could
inhibit economic growth and widen the already substantial current
account deficit. The memorandum noted that hopes for a stable
post-election period and a resumption of capital flows into Mexico
had not materialized. The September 24 announcement of a new Pacto,
it said, had not had the desired effect of strengthening the peso; it
was soon offset by renewed concerns over political stability as a
result of the September 28 assassination of PRI's Secretary General
Ru�z Massieu. In addition, the memorandum observed, the PRI appeared
to be beset by an internal struggle between reformers and old-liners,
and tensions had recently increased in Chiapas. Although capital
flight seemed negligible, so too was additional foreign portfolio
investment. In addition, the memorandum advised that although the
market had seemed pleased with Mexico's October 14 announcement of
$17.2 billion in international reserves, Mexican financial officials
would be hard-pressed to keep reserves at or above that level.
In connection with the latter point, the memorandum indicated concern
that Mexican officials might request an activation of the U.S.-Mexico
swap facility on the occasion of their next public announcement of
foreign exchange reserves (possibly on November 1) if the level of
reserves was not as high as it had been on October 14. The document
indicated that Treasury would need to carefully consider such a
request because the result could be to mislead the market\4 and that
Treasury would want to explore future reforms as part of any
activation. The memorandum suggested that the Secretary advise the
Finance Minister that Treasury remained concerned about Mexico's
exchange rate policy because it left little room to accommodate
additional pressures with the peso remaining so close to the top of
the exchange rate band.
The memorandum also indicated that Treasury staff thought Mexico had
made a commitment in July to change its exchange rate when the United
States had lined up European support for a swap facility. However,
high-level U.S. officials advised us that Mexico's July commitment
was superseded following the August presidential election when
substantial pressure on the peso did not develop.
A November 7 Federal Reserve analysis reviewed key factors and events
that had influenced Mexican financial markets between September 27
and November 7. The analysis concluded that much of the earlier
period had been disillusioning for Mexico and its financial market
participants. Although the national election and the renewal of the
Pacto were out of the way, most market participants had expected a
rosy future of an appreciating peso and declining interest rates--in
spite of uncertainty about U.S. interest rates and a heavy maturity
schedule for Mexico's dollar-indexed tesobonos. According to the
memorandum, the assassination of the PRI Secretary General and a
subsequent linking of party members in the murder plot had deepened
concerns about party factions and resistance to change. Further, it
said, the peso remained under pressure for most of the period as
capital was not entering the country as quickly or in as great a
quantity as had been hoped for following the election and the Pacto
agreement. Foreign investors had become more careful concerning
Mexico, and daily dollar/peso volumes had thinned dramatically.\5
This trend was given added strength, the memorandum said, by rising
interest rates in the United States, which increased pressure on
Mexican interest rates and the Bolsa. The analysis noted that $2
billion in tesobonos had matured during the last week of September,
that $4.1 billion had matured in October, and that $2.8 billion were
scheduled to mature in November. The analysis further noted that
Mexican corporate earnings releases had shown mixed results.
The November 7 analysis expressed surprise at the market's resilience
and the continued credibility of Mexico's currency bands and noted
that the Bank of Mexico had not had to intervene even once from
September 27 to November 7. The analysis further stated that on
October 19, Mexican foreign exchange reserves had been announced at
$17.2 billion, and on November 1, reserves were announced as slightly
higher, at $17.24 billion. Looking to the near-term future, the
analysis said that market participants were anticipating the December
1 inauguration of Zedillo as president and that, barring additional
"unexpected" political events or shocks, the market was not expecting
activity to pick up substantially before the beginning of 1995.
Mexican markets would continue to be influenced by major changes in
the United States and its markets. The analysis also anticipated
that foreign investors would gradually send new capital to Mexico.
A substantial run on the peso began November 14. The Bank of Mexico
intervened in the foreign exchange market for the first time since
August 16 (when it had sold $25 million for pesos) and before that on
July 21 (when it had sold $100 million for pesos). Meanwhile, for
domestic monetary policy reasons, the U.S. Federal Reserve Board's
FOMC met on November 15 and decided to raise the U.S. federal funds
rate by 0.75 percent. According to a Federal Reserve official,
Mexico made an important technical mistake on that day by not raising
its interest rates to offset the increase in U.S. rates. As a
result, the official said, Mexico lost a considerable amount of its
foreign currency reserves. At this point, according to the official,
the consensus view at the Federal Reserve was that Mexico would be
forced to make an adjustment within a matter of "days, weeks, or
months." (According to Bank of Mexico figures, Mexico's foreign
reserves were drawn down $3.4 billion between November 14 and
November 18. Most of the drawdown occurred between November 16 and
18.)
A November 16 Federal Reserve document reported that the peso was
under pressure and the Bank of Mexico was selling dollars. According
to the document, market participants were expressing concerns that
interest rates were not high enough to attract capital needed to fund
the current account deficit, but higher rates would be detrimental to
economic growth. A Federal Reserve document of November 18 reported
that Mexican markets were in turmoil because of rumors about Chiapas
and the political situation with PRI. It reported that the trade
deficit was up, and the current account deficit was causing increased
concern and contributing to foreign exchange reserve losses. In
addition, the analysis said, the U.S. market and other financial
markets were looking more attractive to investors. The document
concluded that there was a real question about the sustainability of
the Mexican situation.
Mexican authorities met on the weekend of November 19 and 20 to
decide whether to adjust Mexico's exchange rate policy and consulted
with U.S. officials several times. According to U.S. officials,
the Treasury Department advised the Mexican Finance Minister that
there was little alternative to changing the policy and that the
Chairman of the Federal Reserve shared this assessment. According to
Treasury Department documents that we reviewed, the Secretary advised
the Mexican Finance Minister during the weekend that it was Mexico's
choice whether to alter its exchange rate system. The documents said
that the Treasury Secretary thought that the Mexicans would
eventually have to allow the peso to depreciate and would have
preferred that they had done so during the weekend. According to the
records, the Mexican officials had considered devaluing during that
weekend but had rejected the option because they felt the political
situation would not allow it. Chiapas was cited as one factor; the
need for labor support another. Mexican officials decided against
adjusting the exchange rate policy at that time.\6 On the evening of
November 20, President-elect Zedillo went on Mexican television and
announced that he supported maintaining the existing exchange rate
policy and Pacto.
--------------------
\4 A memorandum prepared on October 19 for the Federal Reserve
Chairman showed that the Federal Reserve officials suggested that
Mexican officials be counseled that they could not count on using
U.S. swap facilities to sustain an inappropriate exchange rate.
\5 A November 10 staff memorandum prepared for a senior Treasury
official noted that U.S. interest rates were rising relative to both
cetes and tesobonos, narrowing the differences that had favored
Mexican assets. The memorandum noted that this development might be
contributing to some reduction in foreign portfolio investment in
Mexico.
\6 According to an account by Mexico's then Finance Minister,
high-level Mexican officials who met on November 20 were initially
divided on what to do--with some favoring an immediate devaluation of
10 to 15 percent, some favoring letting the exchange rate float, and
some supporting a drastic tightening of monetary policy to increase
interest rates significantly. According to the account, they
eventually reached consensus not to devalue if a reaffirmation of the
Pacto stopped the speculative attack on the peso. See Pedro Aspe,
"Mexico's Ex-Finance Minister Sets the Record Straight," Wall Street
Journal (July 14, 1995).
NOVEMBER 21 TO DECEMBER 20,
1994
-------------------------------------------------------- Chapter 3:3.2
Between November 21 and December 20, U.S. officials continued to
closely monitor peso developments. Documents that we reviewed for
the period through December 15, 1994, showed that although U.S.
officials thought that Mexico would eventually have to adjust its
exchange rate or macroeconomic policy, they were not convinced that
an adjustment would have to be made before 1995. There was no
indication in the documents we reviewed that U.S. officials thought
a forced devaluation of the currency would lead to a severe financial
crisis requiring a major assistance package. The absence of any such
indication in the documents was confirmed by officials. For example,
a Treasury official told us that when Mexican officials decided not
to devalue, following their meetings on November 19 and 20, he felt
they were making a mistake. However, he had no idea that the
consequences would be so immediate or--after they did devalue--so
devastating. Barring Mexico's adjusting its exchange rate or
macroeconomic policy, U.S. officials were reluctant to allow Mexico
to use its swap facility to support the peso.
On November 21, a senior Treasury official advised the Secretary that
the peso had been slightly stronger in early morning trading
following Zedillo's reaffirmation of the Pacto and the existing
exchange rate policy. He noted that traders had indicated some
disappointment that Zedillo's statement had not had a more positive
impact and that the Bank of Mexico had raised its overnight lending
rate. He also noted that there were reports of violence in Chiapas
and fears of violence following victory by PRI's candidate in the
Tabasco state gubernatorial race.
In a November 22 memorandum, a senior official again advised the
Secretary that Zedillo's television appearance on November 20
appeared to have calmed Mexico's foreign exchange market but noted
that it was too early to say that near-term market sentiment on the
peso had been reversed. If missteps were avoided, the official said,
the current exchange rate should be maintainable through the December
1 inauguration of Zedillo. Looking further ahead, he said, there was
a significant risk that pressure on the peso might resume and that
Mexico would be forced to make an adjustment to the exchange rate
band within which the peso was trading. The official advised the
Secretary that he and his staff did not believe it would be useful
for Mexico to draw on its swap line to defend an overvalued peso. In
addition, he informed the Secretary that the results of a Mexican
auction of tesobonos on November 22 suggested that investors saw some
increased risk of a devaluation. However, on the same day, a U.S.
embassy official in Mexico City advised Washington that he had spoken
to a number of sources in Mexico who had concerns about the peso over
the short term but still expressed confidence that the Mexican
government would not devalue the peso. In addition, he said, his
sources were optimistic about the peso for 1995.
According to a talking points paper prepared for a November 23
meeting between the Treasury Secretary and President-elect Zedillo,
the Treasury Secretary was advised to tell the President-elect that
Mexico's current account deficit was clearly giving financial markets
reason for concern about Mexican competitiveness. If Zedillo were to
ask about using the swap line with the United States to support the
peso, the Secretary was advised to tell him that it would not be
helpful to draw on the swap at that time. If Zedillo were to ask the
United States to support the peso directly, the Secretary was advised
to tell him that that was not a viable option, given the market risk
attached to the peso in its current band.
A December 8 Federal Reserve briefing on overnight headlines noted
that tensions were rising in Chiapas as peasant groups and guerrilla
leaders warned of military action in a bid to prevent the ruling
party's Governor-elect, Eduardo Robledo, from taking office. The
briefing paper said that Robledo had been elected with 50 percent of
the vote in the August election, but opposition parties and rebel
chiefs had claimed massive fraud.
A December 15 Federal Reserve briefing report on overnight
developments noted that President Zedillo, in a nationally televised
address, had stated that the Chiapas conflict represented a constant
threat to public calm, peace, and justice, and he had instructed the
Mexican Congress to form a multiparty commission to negotiate with
EZLN. A December 15 Treasury memorandum for a senior Treasury
official reported that the peso had weakened from the previous day
and said that the decline could be due to the rejection of renewed
peace negotiations by the shadow opposition government in Chiapas and
possibly also to a December 15 Wall Street Journal article on the
weakness of the peso.\7 The memorandum noted that Mexico's reserve
assets might have fallen well below $12 billion. On a positive note,
the memorandum said that the volume of activity on the foreign
exchange market was low and was likely to drop even further as
Mexicans took a long break over Christmas. This, the document said,
should help ease pressures on the peso for the next several weeks.
A Federal Reserve analysis covering the November 15 to December 15
period concluded that Mexican policymakers arguably were reaching a
juncture in which funding Mexico's current account deficit (estimated
at $28 billion, or approximately 8 percent of GDP) would require that
interest rates increase significantly, which could dampen growth
prospects, or that the peso be allowed to depreciate at a greater
rate. The analysis noted that rising U.S. short-term interest rates
had put upward pressure on Mexican rates and had weighed on Mexican
corporate earnings. Drops in the U.S. stock market and in U.S.
long-term bond prices, it said, had spilled over into the Mexican
stock market. And competition for capital by countries such as
Brazil had grown significantly over the period. According to the
analysis, the peso had traded during the period near the level at
which the Bank of Mexico normally intervened, prompting more than
$4.8 billion in sales by the Bank.
With regard to Chiapas, the analysis said that Robledo had taken
office on December 8 amid widespread protest, including a declared
end of the cease-fire by rebels and the claim of a leading opposition
candidate to hold the office of "parallel" governor. No major
violence took place, and the market had reacted well at the time, the
document said; however, tension was reignited during December 13
through 15 with the Zapatista threat of imminent war and subsequent
false rumors of shooting. The Mexican stock market fell to a 4-month
low. Looking to the end of 1994 and the first quarter of 1995, the
analysis forecast ongoing upward pressure on Mexican interest rates
and said that the peso might continue to trade close to the upper
limit of the band. Decreasing portfolio allocations to Mexico were
likely to continue, it said.
A December 19 Treasury memorandum expressed concern that Mexico might
move to change its exchange rate policy before Christmas and without
consulting Treasury. The document urged that the Treasury contact
Mexico before this occurred. According to the document, Mexico's
foreign reserves might have fallen to below $11 billion\8 as the week
began. According to the memorandum, investors were not worried about
the size of the current account deficit or a devaluation but about
Chiapas and the possible spread of political unrest. Thus, the
memorandum said, a devaluation by the Mexican government would not
necessarily lead to a resumption of capital inflows. The document
predicted that if foreign investors started to extricate themselves
from Mexico, it would be a matter of days before Mexico took some
type of action.
Written remarks for the Federal Reserve's December 20 FOMC morning
meeting, prepared before the Federal Reserve had learned that Mexico
had devalued its peso, indicated that Federal Reserve officials
expected an announcement on December 20, as well. However, this
document said that the Federal Reserve was not certain whether the
change would be a discrete adjustment in the band or a float of some
kind.
--------------------
\7 Craig Torres, "Foreign Exchange: Peso's Plunge Rocks Confidence
in Investing in Mexico."
\8 According to Bank of Mexico data, reserves were $11.1 billion on
Friday, December 16, and reached $10.5 billion on Monday the 19th.
SHOULD THE ADMINISTRATION HAVE
PROVIDED MORE FORCEFUL ADVICE
TO MEXICO?
---------------------------------------------------------- Chapter 3:4
Some observers have argued that, during 1994, U.S. officials should
more forcefully have conveyed their concerns over Mexico's economic
and financial situation to Mexican officials or that the U.S.
officials should have publicly revealed these concerns. We found no
clear evidence from our documentary review or interviews indicating
that at any given time in 1994, U.S. officials found the evidence
and analyses that the peso needed to be devalued sufficiently
compelling for them to provide more adamant advice than they did to
Mexico. Also, U.S. officials had confidence in the competence of
Mexican economic management and were sensitive that because Mexico is
a sovereign country, decisions on whether and how to change Mexican
economic policies ultimately rested with Mexico. In addition,
documents and interviews with U.S. officials indicated that U.S.
officials did not foresee that if Mexico were later forced to devalue
because of failure to act in a timely way, the consequences would be
as severe for Mexico and for other developing countries as they
turned out to be. One reason U.S. officials did not publicly
discuss their concerns over Mexico's financial situation was because
they were concerned about provoking a sudden flight of capital from
Mexico.
DIFFICULTY IN ARGUING WITH
CERTAINTY THAT THE PESO
SHOULD HAVE BEEN DEVALUED
-------------------------------------------------------- Chapter 3:4.1
It is not apparent from the evidence we reviewed that at any time
during 1994, the case that the peso was overvalued and should be
devalued was so compelling that U.S. officials believed they could
argue that they were certain that Mexico should devalue. One U.S.
official told us that Mexican officials' arguments for not devaluing
the peso seemed plausible for much of the year and that the U.S.
government was more convinced that a devaluation was necessary than
was IMF. As chapter 2 discusses, the fact that drawdowns in Mexico's
foreign currency reserves tended to come after unexpected political
events, such as the Colosio and Massieu assassinations, would have
lent credibility to the Mexican view. Also, as discussed earlier in
this chapter, various U.S. government analyses differed over whether
the peso was overvalued and, if so, whether and how Mexico should
devalue. A Treasury official told us that Treasury lacked the "hard
evidence and economic analysis" that would have allowed it to argue
firmly in its discussions with Mexican authorities that devaluation
was the only course to address the current account deficit. Also, he
said, no country had experienced the kind of meltdown that happened
to Mexico at the end of 1994 and that Treasury did not anticipate
such a meltdown.
Further, U.S. officials did not sufficiently focus on the
possibility that if Mexico were to devalue, investors might panic and
cease rolling over (reinvesting in) tesobonos, and thus drive Mexico
to the brink of default. By the beginning of December 1994, Mexico
had tesobono obligations of $30 billion due in 1995, while foreign
exchange reserves had fallen to $10 billion. As discussed earlier in
this chapter, a few analyses that we reviewed pointed to the
increasing levels of tesobono obligations, but they did not
specifically raise the possibility of such a rollover problem. A
Federal Reserve official told us that, in hindsight, Federal Reserve
officials assumed that Mexico would be able to roll over tesobonos
completely, but that they should have considered the possibility that
investors would seek to redeem all the tesobonos. Similarly, a
senior Treasury official said that if Treasury officials had focused
more on tesobonos, this might have led them to pay more attention to
the potential rollover problem and the possibility of default.
Moreover, U.S. officials pointed out that the differential between
interest rates on Mexican and U.S. government securities indicated
that financial markets perceived a low likelihood of a Mexican
devaluation or default during much of 1994.\9 As previously
discussed, a Federal Reserve analysis of August 19, 1994, evaluated
differentials between interest rates on Mexican cetes and U.S.
Treasury bills to estimate how financial markets were calculating the
implied probability of a peso devaluation. The analysis concluded
that because the differential was fairly small, financial markets
perceived only about a 6-percent chance of a 20-percent devaluation
during the next 3 months and a 15-percent chance during the next
year. The analysis also estimated financial markets' perceptions of
a Mexican government default on its tesobono obligations that would
cost investors about 20 percent of the value of their tesobonos.\10
The analysis estimated financial markets' perceptions of a default on
tesobonos to be about 4 percent over the next 3 months and 16 percent
over the next year.
Further, as figure 3.2 shows, from August to the end of October, the
differential between cete and U.S. Treasury bill interest rates, and
between tesobono and U.S. Treasury bill interest rates, narrowed.
This implies that financial markets' perceptions of a Mexican
government devaluation or default on its dollar-linked tesobono
obligations were diminishing.
Figure 3.2: Yields on Mexican
Cetes, Tesobonos, and U.S.
Treasury Bills, 1994
(See figure in printed
edition.)
Note: Tesobono and cetes data are end-of-month data. U.S. Treasury
bill data are monthly averages.
Sources: Bank of Mexico, U.S. Treasury Department.
--------------------
\9 The interest rate carried by a sovereign government debt security
reflects different kinds of risk that the purchaser of the debt
bears, including the risks that the country will (1) devalue its
currency, often called the "foreign exchange risk"; and (2) default
on the debt, usually called the "transfer" or "default risk."
Comparing the differential between Mexican and U.S. government debt
securities over time in 1994 can indicate whether investors'
perception of the risk of a peso devaluation or Mexican government
default on these obligations was increasing or decreasing.
\10 The analysis assumed that were the Mexican government to devalue
the peso by 20 percent and then suspend the indexation of tesobonos
to the peso-dollar exchange rate or the convertiblity of tesobonos
into their equivalent value in dollars, this would be equivalent to
an act of default that would cause investors to lose about 20 percent
of the value of their tesobonos.
OTHER REASONS FOR NOT
PROVIDING STRONGER ADVICE
-------------------------------------------------------- Chapter 3:4.2
A Senior Treasury official has testified before Congress that because
Mexico is a sovereign country, the United States cannot force policy
choices upon Mexican officials. In addition, our review of Treasury,
State Department, and Federal Reserve documents and interviews with
agency officials indicated that U.S. officials did not foresee that
the Mexican devaluation would lead to a sudden, virtual abandonment
of Mexico by foreign investors and a threat of imminent default by
Mexico on its nonpeso-denominated debts. For example, a senior
Treasury official told us that as 1994 progressed, Treasury saw a
growing risk that the markets would force a devaluation of the peso.
However, he said, if a devaluation occurred, he did not believe that
Mexico would experience the kind of crisis that would bring it to the
brink of default, like the Mexico crisis of 1982. Another Treasury
official told us that by mid-December Treasury expected that a modest
devaluation would occur and that if Mexican interest rates were high
enough, the situation would stabilize. The official said that he
thought that the adjustment needed to stabilize Mexican financial
markets was considerably less than the 15-percent devaluation
implemented by Mexico on December 20. Similarly, a Federal Reserve
official told us that he was "very surprised" that the 15-percent
devaluation of December 20 did not hold, because he believed that
only a 10-percent devaluation was necessary to stabilize financial
markets.
Also, U.S. officials did not anticipate that Mexican authorities
would mismanage the December 20 devaluation and thus exacerbate the
devaluation's effect on investor confidence in Mexico. In March 10,
1995, testimony before the Senate Committee on Banking, Housing, and
Urban Affairs, a senior Treasury official attributed the December
1994 financial crisis in part to Mexican authorities' "mishandling"
of the devaluation.
Some observers have also argued that administration officials should
have publicly aired their concerns during 1994 over Mexico's economic
situation and policy course. They assert that the administration had
an obligation to provide the public with its assessment of whether
the peso was overvalued and what actions Mexico should have taken to
correct its financial situation--especially in light of the fact that
Mexican authorities had chosen not to adjust their policies despite
administration counsel to do so. A principal reason why U.S.
officials did not publicly discuss their misgivings about Mexico's
financial situation was out of concern that such statements could
cause investors to suddenly withdraw funds from Mexico, triggering
financial difficulty for Mexico. Also, it is not clear that the U.S.
government possessed any information in 1994 on Mexico's financial
situation that private financial markets did not have or were not
capable of piecing together from their own sources.
A senior Treasury official told us that he did not believe that the
Treasury had important, substantive information that financial
markets did not have. The official said that data on Mexico's
current account, interest rates, and overall amounts of tesobonos
outstanding were public. It was a little hard to know what the
markets knew about Mexico's foreign exchange reserves on a
moment-to-moment basis, he said, but the markets seemed to be aware
of broad trends in Mexico's reserve levels. According to the
official, Treasury's assessment of Mexico's situation differed from
that of financial markets, but markets have their own way of
processing information and are capable of drawing different
conclusions. The official said that he did not think it would be
appropriate for Treasury to take a public position about whether or
not a foreign currency was overvalued. At the same time, he said
that emerging market countries need to disclose publicly more
financial information and do so more frequently, so that market
participants can make their own judgments.
IMF ADVICE TO MEXICO
---------------------------------------------------------- Chapter 3:5
IMF completed a major review of Mexico's foreign exchange policy and
economic policies in February 1994. The review did not indicate a
need to change the policy. Further, Treasury and IMF officials told
us that IMF eased off its surveillance of Mexico during the second
half of 1994 when the foreign exchange reserves appeared to have
stabilized after the sharp drop in the spring, did not foresee the
crisis, and did not see a compelling case for Mexico to alter its
exchange rate policy before the December 20, 1994, devaluation.
FEBRUARY 1994 IMF ARTICLE IV
CONSULTATION
-------------------------------------------------------- Chapter 3:5.1
IMF typically holds consultations every year with each of its members
to obtain information on whether the member country is acting
responsibly and openly in setting the conditions under which its
currency is bought and sold by governments and private citizens of
other countries, as well as information on the country's overall
economic position. This process is referred to as an "article IV
consultation," since it is related to article IV of the IMF Articles
of Agreement.
As part of the process, a team of IMF staff members is to travel to
the country's capital and spend several weeks gathering information
and holding discussions with government officials about the country's
economic policies. The process includes discussions with
high-ranking government officials to find out how effective their
economic policies have been during the previous year and what changes
might be anticipated during the coming year. They also are to
inquire about what progress the country has made in eliminating
whatever restrictions it has on the exchange of its currency. When
these meetings are over, the team is to return to headquarters in
Washington, D.C., to prepare a detailed staff report for discussion
by the IMF executive board. The IMF Executive Director of the
country under review is to take part in the discussion, clarifying
points about the country's economy and listening to the evaluation by
other executive directors. A summary of the discussion, often
containing suggestions about how to strengthen areas of economic
weakness, is later to be transmitted to the member's government.
During February 1994, IMF executive directors met to discuss Mexico's
article IV consultation. According to IMF, the consultation took
place against a background, during 1993, of a continued surplus in
public finances, a reduction in inflation, and further progress in
structural reform, as well as a decline in the external current
account deficit by more than 1 percentage point, to 5.7 percent of
GDP.\11 IMF noted that Mexico's current account deficit was more than
covered by capital inflows. During the discussion, the executive
directors expressed satisfaction with Mexico's narrowing of the
external current account deficit in 1993, which was attributed in
part to Mexico's economic slowdown and the unwinding of the
consumption boom of the past few years, as well as to a rapid growth
in nonoil exports. Executive directors stressed Mexico's need to
lower the deficit further with the aid of policies designed to
strengthen private savings and to maintain high levels of public
savings. According to IMF, some directors expressed concern about
the outlook for Mexico's competitive position, but it was generally
noted that notwithstanding the real appreciation of the peso in
recent years, Mexico's manufacturing exports continued to register
strong gains. However, since further real appreciation of the peso
could pose risks to the continued export expansion, directors
emphasized the importance of Mexico's lowering inflation, restraining
wages, and continuing structural steps to ensure export market
competitiveness and labor market flexibility.
According to a Treasury Department official, during the article IV
consultation in February 1994, the United States expressed concern
about the size of Mexico's current account deficit and GDP growth.
The official said that IMF staff acknowledged concerns about Mexico's
lack of growth but argued that Mexico's peso valuation was
acceptable. Although some economists were arguing that the peso was
overvalued, the official said, most economists and IMF staff believed
that Mexico's rising level of exports meant that the peso was
competitive. IMF staff noted that Mexico had balanced its budget,
had gotten inflation under control, and had begun to restructure its
economy by liberalizing trade and privatizing its industries. In
addition, staff indicated that capital inflows showed investors were
confident about Mexico.
--------------------
\11 1994 International Monetary Fund Annual Report, IMF (Washington,
D.C.: Apr. 30, 1994).
IMF DID NOT FORESEE MEXICO'S
CRISIS
-------------------------------------------------------- Chapter 3:5.2
According to a senior IMF official that we interviewed, IMF staff did
not closely monitor Mexican developments during the latter half of
1994 and, like other informed observers, did not predict the crisis.
The official said that IMF had done a post-crisis study to determine
why it had missed the crisis. Among reasons cited by the official
were the following:
IMF was not monitoring countries on a "real-time" basis. For
example, staff were not tracking real-time data on Mexican
tesobonos during 1994.\12
IMF had become too tolerant of a fall off in the quality and
timeliness of data provided by member countries that were no
longer in an IMF-supported adjustment program. Mexico had not
had a program with IMF since May 1993.
Mexico had a very well-respected economic team, including its
Finance Minister. IMF staff tended to give Mexico the benefit
of the doubt.
A Treasury official that we interviewed cited several reasons why IMF
failed to foresee Mexico's exchange rate crisis.
The IMF article IV consultation occurred before the crisis
developed. Mexico's 1994 consultation took place early in the
year, well before the December crisis. Although some other
discussions were held between IMF staff and Mexican officials
during the year, there clearly was a need for more monitoring.
Timely reporting of some data by Mexico was lacking. This was a
problem with many member countries. IMF staff did not
aggressively seek information; they waited for member countries
to provide it.
IMF staff were not paying enough attention to external market
borrowing by countries. IMF country evaluations focused too
much on examining whether the fiscal account was balanced and
did not focus enough on private markets.
IMF staff doing financial market analysis were working
independently from IMF country teams.
According to the Treasury official, although IMF failed to predict
the crisis, it was not alone. According to the official, major
investment firms were advising clients to invest in Mexico as late as
November 1994, saying that the government of Mexico was committed to
not devaluing the peso. In addition, the official said, reasons
offered by the Mexican government for not devaluing the peso were
plausible throughout the year.
According to the Treasury official, the most important event that IMF
staff and Mexican officials missed in their analyses during the year
was the rise in U.S. interest rates and how that affected investment
in Mexico. U.S. interest rate increases coincided with important
political shocks that occurred in Mexico during the year. According
to the official, analysts attributed the decline in financial flows
into Mexico primarily to the political events. But, the official
said, rising U.S.interest rates changed the investment calculation
for most investments.
--------------------
\12 According to the official, IMF is making progress in developing a
real-time surveillance capability.
CONCLUSIONS
---------------------------------------------------------- Chapter 3:6
We found that Treasury, State Department, and Federal Reserve
officials had some concerns about Mexico's ability to sustain the
peso's valuation in early 1994 due to Mexico's large current account
deficit and the real appreciation of the peso relative to the dollar
during the preceding several years. However, at that time, Mexico
was attracting large flows of foreign capital and had sizable foreign
currency reserves. Concerns increased following the Colosio
assassination as large amounts of Mexican reserves were drawn down.
However, the U.S. officials thought the peso exchange rate was still
sustainable and made swap facilities available to help Mexico
maintain orderly exchange rate markets. In July, the United States
and BIS, backed by other countries' central banks, organized a large
contingency swap facility designed in part to help get Mexico through
its August election. U.S. officials were sufficiently concerned by
that time to secure an oral understanding from Mexico that if
pressure on the peso continued beyond the election, Mexico would make
some adjustments.
Substantial pressure on the peso did not resume following the
election; however, capital inflows also did not resume, as had been
expected by Mexican officials. During October and November 1994,
U.S. officials advised Mexican officials that they believed the peso
probably was overvalued and that it was a risky strategy to try to
maintain the existing exchange rate policy. However, Mexican
officials chose not to adjust the exchange rate policy at that time.
Immediately following the renewed attack on the peso and substantial
drawdown of Mexican foreign currency reserves during the third week
of November, U.S. officials indicated that they thought Mexico did
not have much alternative to adjusting its exchange rate and had
discussions with Mexican officials about Mexico's policy options. By
mid-December, U.S. officials were expecting that Mexico would be
forced to devalue its currency in the near future, but not
necessarily before the end of the year.
U.S. officials had several reasons for not having given stronger
advice to Mexico to devalue the peso in 1994. The evidence that the
peso was overvalued and had to be devalued was not sufficiently
compelling to be persuasive to Mexican authorities. Also, U.S.
officials have publicly stated that they were sensitive to the fact
that a decision to devalue the peso ultimately rested with Mexico and
had confidence in the competence of Mexican economic management.
Finally, documents indicate that U.S. officials did not foresee that
a devaluation would lead to a financial crisis for Mexico and a
multibillion-dollar assistance package from the United States.
U.S. AND IMF RESPONSE TO THE
CRISIS
============================================================ Chapter 4
After it appeared that an initial proposed package of $40 billion in
U.S. guarantees would fail to gain needed congressional support, a
multilateral response to the Mexican crisis, primarily with United
States and International Monetary Fund (IMF) participation, was
created. The main aim of this assistance was to help Mexico avoid
financial collapse and to limit any spread of the crisis to other
emerging market economies. The U.S. portion of the package uses ESF
funds and Federal Reserve funds backed by ESF. Treasury has the
requisite authority to use ESF to provide assistance to Mexico. In
exchange for the assistance, Mexico agreed to abide by terms and
conditions specified in the U.S. and IMF assistance packages,
including paying interest and fees, providing additional repayment
assurance to the United States through a mechanism allowing set-off
against revenues from the export of Mexican oil, implementing a
comprehensive and stringent economic plan, and providing economic
information on a timely basis.
THE INITIAL U.S. ASSISTANCE
PACKAGE
---------------------------------------------------------- Chapter 4:1
On January 12, 1995, the President announced a proposed $40-billion
loan guarantee package for Mexico and began seeking congressional
approval. According to statements by the Secretary of the Treasury,
the U.S. government would guarantee payment of up to $40 billion in
new private sector loans to the Mexican government. Mexico was to
use these loans to reduce its short-term obligations. In exchange
for these guarantees, Mexico would pay a guarantee fee to the United
States. The package also provided that Mexico would pay a
supplemental interest rate on any guaranteed borrowing above market
rates. This higher rate was to encourage Mexico to limit the use of
guarantees and return to private capital markets as soon as possible.
As with the subsequent package, this $40 billion of assistance would
have been contingent on Mexico's making changes in its economic
policies.
THE U.S. AND IMF ASSISTANCE
PACKAGE
---------------------------------------------------------- Chapter 4:2
On January 31, 1995, after it appeared that the package would not
attain sufficient congressional support, the administration announced
in its place a $48.8-billion multilateral assistance package to
respond to the Mexican financial crisis. The U.S. portion of this
package included up to $20 billion in currency swaps and securities
guarantees from Treasury's ESF, which the Treasury Secretary may use
for certain authorized operations without a congressional
appropriation.\1 On the same day, IMF announced an 18-month,
$17.8-billion standby credit arrangement for Mexico. The
multilateral assistance package also included $10 billion from other
industrial countries through BIS and $1 billion from Canada.\2 It was
also originally said to include funds from two Latin American
countries and additional loans from commercial banks.\3
--------------------
\1 The short-term swaps include up to $6 billion that may be provided
by the Federal Reserve Bank of New York acting at the direction of
the Federal Reserve's FOMC. The Treasury Department has agreed to
provide backing for these swaps by assuring repayment of any drawings
under the $6-billion swap arrangement.
\2 In early January, BIS announced a $5 billion facility, which was
later increased to $10 billion. BIS funds were short term and have
not been drawn upon by Mexico. The Bank of Canada established a swap
facility with the Bank of Mexico as part of an April 1994 trilateral
swap facility. By the end of January 1995, the Bank of Canada had
already activated its short-term swap arrangement with the Bank of
Mexico.
\3 Initial commitments from Argentina and Brazil for $1 billion to
participate in the assistance package were withdrawn when these
countries experienced a reaction from Mexico's crisis, and capital
fled. There was also an announcement of efforts to raise funds from
a group of international commercial banks and a group of investment
banks.
OBJECTIVES OF THE U.S. AND IMF
ASSISTANCE PACKAGES
---------------------------------------------------------- Chapter 4:3
The primary purpose of this assistance was to help Mexico overcome
its short-term liquidity crisis and thereby prevent Mexico's
financial collapse. Treasury, Federal Reserve, and IMF officials
believed that providing immediate assistance would limit the effects
of Mexico's crisis from spreading to the economies of other emerging
market nations and beyond. For the United States, an additional
concern was to limit the negative effects of the crisis in the areas
of trade, employment, and immigration.
U.S. officials judged that Mexico's imminent financial collapse
could be prevented, and investor confidence in Mexico restored, by
making available large amounts of money to allow for the refinancing
of a large portion of Mexico's maturing short-term liabilities.
Specifically, they believed that the package would allow Mexico to
redeem debt that was immediately coming due, and refinance debt that
would be coming due in the near future, with debt of longer maturity.
Further, U.S. officials believed that these actions would prevent
Mexico's liquidity crisis from becoming a solvency crisis. The
assistance package also allowed the government of Mexico to help
Mexican banks meet their dollar obligations. Several Mexican banks
had large amounts of dollar-denominated certificates of deposit that
were coming due, and the assistance package would facilitate their
redemption and avert further deterioration of Mexico's dollar
reserves.
Both the United States and IMF were concerned that the loss of
confidence in Mexico's economy would spread to other emerging market
countries and would disrupt capital flows to these countries. Early
in the crisis, financial markets in Brazil and Argentina, among other
emerging market countries, were affected by Mexico's problems as
investors began to limit capital flows to these countries. According
to the Secretary of the Treasury, as well as government and industry
analysts, Mexico has been a paradigm for countries that are striving
to put inward-looking, state-controlled models of economic
development behind them and move to free market models. The
Secretary also noted that new prosperity, based on open markets,
encouraging investment, and privatization of state-controlled
industries, is beginning to be realized in these emerging market
countries. Other U.S. government officials stated that they
believed a spread of Mexico's financial difficulties to other
emerging markets could have halted or even reversed the global trend
toward market-oriented reform and democratization. Senior Federal
Reserve officials also stressed that an objective of the package was
to halt the erosion in Mexico's financing capabilities. Stock market
indexes for emerging markets, compiled by the International Finance
Corporation (IFC)\4
showed that markets in Argentina and Brazil in particular suffered
heavy trading losses immediately after the Mexican crisis (see figs.
4.1 and 4.2). Table 4.1 charts the issuance of new equities in
selected emerging markets in the period surrounding the Mexican
financial crisis.
Figure 4.1: Argentina's Stock
Market Index, August 1993 -
August 1995
(See figure in printed
edition.)
Source: IFC Emerging Markets Data Base--investable index series.
Figure 4.2: Brazil's Stock
Market Index, August 1993 -
August 1995
(See figure in printed
edition.)
Source: IFC Emerging Markets Data Base--investable index series.
Analysis of stock market trends summarized in table 4.1 shows that
there were virtually no new issues of international equities in
Brazilian, Argentine, and other emerging markets in the first quarter
of 1995.
Table 4.1
International Equity Issues in Selected
Emerging Markets, 1994-95
(U.S. dollars in millions)
Country 1994Q2 1994Q3 1994Q4 1995Q1 1995Q2
-------------------- -------- -------- -------- -------- --------
Argentina $643.2 $75.2 $153.0 0 $146.1
Brazil 138.0 857.4 179.7 0 110.0
Chile 319.0 198.1 195.3 0 0
China 530.6 782.8 832.5 0 496.9
Indonesia 171.9 1,183.2 114.4 0 0
Mexico 898.2 63.2 260.3 0 0
----------------------------------------------------------------------
Sources: Euromoney Bondware and World Bank data.
In addition to the U.S. and IMF objectives outlined previously, the
United States had other objectives that addressed U.S.-specific
interests. According to the Secretary of State and other U.S.
government officials, the United States has a fundamental national
interest in making sure that financial confidence in Mexico is
restored. Due to growth in the Mexican economy--particularly over
the last decade--and the economic interdependence between the United
States and Mexico, the United States has both strategic and economic
interests in the Mexican economy.
The United States also has an interest in protecting trade with
Mexico and thereby limiting U.S. job losses stemming from the
crisis. Mexico is the third-largest market for U.S. exports and the
third-largest source of U.S. imports. According to the Secretary of
State, if the United States had failed to act, U.S. exports to
Mexico--now valued at $40 billion a year--would have been severely
affected. Many of the 700,000 jobs those exports support could have
been jeopardized in that event.
Based on their belief that immigration from Mexico is inversely
related to Mexican economic growth, U.S. officials were also
concerned that turmoil in the Mexican economy could be a catalyst for
a surge in illegal immigration to the United States. According to
the Secretary of State, economic distress and political instability
in the wake of the crisis would have added to the pressure that had
already pushed thousands of illegal immigrants across the 2,000-mile
U.S.-Mexican border. According to one Treasury Department estimate,
Mexican illegal immigration to the United States could have increased
by as much as 30 percent per year as a result of economic
difficulties stemming from a financial collapse in Mexico.
--------------------
\4 IFC is a member of the World Bank Group and is a large source of
financing for private enterprise in emerging economies. IFC also
compiles the Emerging Markets Data Base, a statistical resource
tracking market information in developing countries.
TREASURY SECRETARY HAD
REQUISITE AUTHORITY TO USE ESF
FUNDS
---------------------------------------------------------- Chapter 4:4
Under the terms of the assistance package, the Secretary of the
Treasury committed ESF to lend Mexico up to $20 billion through the
following three mechanisms: (1) short-term currency swaps through
which Mexico may borrow U.S. dollars in exchange for Mexican pesos
at a specified rate of interest; (2) medium-term currency swaps for
up to 5 years; and (3) guarantees for up to 10 years under which
Treasury, utilizing ESF funds, would guarantee the payment of all or
part of the principal of and interest on securities to be issued by
the Mexican government. ESF mechanisms are available in conjunction
with the assistance that Mexico has received from other sources,
including IMF assistance of up to $17.8 billion. The stated purpose
of the U.S. assistance package is "to assist Mexico in stabilizing
its exchange and financial markets by providing resources to be used
in such manner as to facilitate the redemption, refinancing or
restructuring of Mexico's short-term debt obligations. . . ."\5
In connection with the use of ESF funds, the Treasury Secretary
received two legal opinions discussing his authority to use ESF. The
Treasury Department General Counsel and Department of Justice
opinions both concluded that the Secretary of the Treasury had the
requisite authority to use ESF to provide assistance to Mexico as
contained in the U.S. assistance package.\6 We have no basis to
disagree based on the following analysis.
--------------------
\5 See section I of the U.S.-Mexico Framework Agreement for Mexican
Stabilization, dated February 21, 1995 (framework agreement).
\6 See letter from Edward S. Knight, General Counsel of the
Department of the Treasury, to Robert E. Rubin, Secretary of the
Treasury, February 21, 1995; and memorandum from Walter Dellinger,
Assistant Attorney General of the U.S. Department of Justice, to
Edward S. Knight, General Counsel of the Department of the Treasury,
March 2, 1995.
USE OF ESF
-------------------------------------------------------- Chapter 4:4.1
Congress established ESF in 1934 pursuant to section 10 of the Gold
Reserve Act of 1934 "for the purpose of stabilizing the exchange
value of the dollar."\7 Since its passage, the statute has been
amended to broaden its purpose from the stabilization of the dollar
to include the promotion of orderly exchange arrangements and a
stable system of exchange rates.\8 In the past, ESF has been used to
buy and sell foreign currencies, extend short-term swaps to foreign
countries, and guarantee obligations of foreign governments.
As amended, the provision governing the use of ESF provides the
following:
"Consistent with the obligations of the Government in the
International Monetary Fund on orderly exchange arrangements and
a stable system of exchange rates, the Secretary or an agency
designated by the Secretary, with the approval of the President,
may deal in gold, foreign exchange, and other instruments of
credit and securities the Secretary considers necessary.
However, a loan or credit to a foreign entity or government of a
foreign country may be made for more than 6 months in any
12-month period only if the President gives Congress a written
statement that unique or emergency circumstances require the
loan or credit be for more than 6 months." 31 U.S.C. � 5302(b).
As set forth in the previous paragraph, section 5302(b) provides
broad authority for the Secretary to provide loans and credits, as
well as deal in "other instruments of credit and securities." We
concur with Treasury's conclusion that the swaps and guarantees fall
within this broad authority. The United States has lent money to
Mexico through short-term swaps (maturity of not more than 6 months)
five times since 1982 and through a medium-term swap (maturity of up
to 1 year) once in 1982. In the past 15 years, ESF has extended
guarantees three times. Treasury used ESF to provide guarantees to
assist Brazil during a financial crisis in 1982 and Yugoslavia in
1983. Later, in 1994, Treasury used ESF to extend a guarantee to
assist Macedonia in paying off arrears to the World Bank.
--------------------
\7 This section was codified at 31 U.S.C. � 5302 as part of the
permanent codification of title 31 in 1982.
\8 This change responded to the country's move away from the gold
standard and a fixed exchange rate. See House Report No. 94-1284,
94th Cong. 2d Sess., 13-14 (1976).
LOAN AND GUARANTEE
MATURITIES PERMITTED UNDER
THE STATUTE
-------------------------------------------------------- Chapter 4:4.2
In the Mexican assistance package, the medium-term swaps may have
maturities of up to 5 years and the guarantees may remain outstanding
for a period of up to 10 years, maturities that exceed all past ESF
loans and guarantees. While these maturities are unprecedented, the
statute does specifically allow the lengthening of maturities if
unique or emergency circumstances exist. In this instance, the
Secretary of the Treasury and the President determined that such
circumstances existed to warrant the longer maturities. If an ESF
loan or credit exceeds 6 months, the statute requires that the
President provide Congress with a written statement that unique or
emergency circumstances exist. The President provided Congress with
this statement on March 9, 1995.
TREASURY SECRETARY CONCLUDED
THAT THE ASSISTANCE PACKAGE
WAS CONSISTENT WITH IMF
OBLIGATIONS OF THE UNITED
STATES
-------------------------------------------------------- Chapter 4:4.3
The statute affords the Treasury Secretary, with the approval of the
President, the complete discretion to decide when the use of ESF is
consistent with IMF obligations of the United States and states
specifically that ESF is under the Secretary's exclusive control.
The statute further provides that in this regard the "[d]ecisions of
the Secretary are final and may not be reviewed by another officer or
employee of the Government" (31 U.S.C. � 5302(a)(2)). In deciding
to implement the assistance package, the Secretary appropriately
exercised the discretion afforded him under the statute.
As required by the statute, the Secretary determined that the
assistance package was consistent with IMF obligations of the United
States on orderly exchange arrangements and a stable exchange system.
These obligations are contained in article IV of IMF's Articles of
Agreement, which is its governing document. Article IV, entitled
"Obligations Regarding Exchange Arrangements," sets out the monetary
policies that IMF members are to follow that affect rates of exchange
between domestic and foreign currencies. Under article IV, members
agree "to collaborate with the [IMF] and other members to assure
orderly exchange arrangements and to promote a stable system of
exchange rates." Particularly, members agree to "seek to promote
stability by fostering orderly underlying economic and financial
conditions and a monetary system that does not tend to produce
erratic disruptions." The Secretary, consistent with the discretion
afforded him under the statute, decided that the assistance package
was consistent with these purposes because the Mexican financial
crisis had a destabilizing effect on the peso's exchange rate and
negative repercussions for the overall exchange rate system. In
addition, IMF announced its own assistance package that served the
same primary objectives as the U.S. assistance package.
ASSURED SOURCE OF REPAYMENT
-------------------------------------------------------- Chapter 4:4.4
Although the statute does not require it, Treasury's policy has been
that ESF loans to foreign countries provide a means to assure
repayment of any funds lent. This policy helps protect ESF against
loss and avoid using ESF as an alternative source of foreign aid.\9
In an effort to assure repayment of any funds lent under the
assistance package were Mexico unable to make timely payments on the
amounts due, Mexico has established a payments facility through which
the proceeds from regular Mexican oil exports could be set off
against to repay unpaid obligations owed to the United States.
Treasury and the Federal Reserve have used this type of oil proceeds
facility in the past to provide an assured source of repayment in
connection with earlier swap arrangements with Mexico. With regard
to the current oil facility, which has some features not present in
earlier facilities, Treasury concluded that this facility provides a
high degree of assurance that the United States will be reimbursed in
the event that Mexico were to default on its repayment. This issue
is discussed in more detail later in this chapter.
--------------------
\9 In connection with Treasury's consideration of a loan to Poland in
1989, Treasury took the position that the loan would not be improper
or illegal, even if there were no assured source of repayment, if the
Secretary concluded that the loan was consistent with U.S.
obligations in IMF and was necessary.
CRITICISMS OF U.S. ASSISTANCE
TO MEXICO
---------------------------------------------------------- Chapter 4:5
Some observers contended that the United States should not have
provided financial assistance to Mexico at all. These critics
usually based their objections on one or more of three arguments.
First, they contended that it was inappropriate for the United States
to protect investors in Mexico by preventing a Mexican government
default on its short-term debt. They maintained that those
investors--including tesobono holders--knew or should have known the
risks associated with their investments, and pointed out that, before
the crisis, they had been rewarded for that risk with a high return.
Consequently, these critics said, U.S. taxpayer funds should not
have been put at risk to prevent those investors from bearing the
consequences of their actions--even if it meant that Mexico would
default on its short-term debts. In fact, it was argued, protecting
certain investors in Mexico from financial losses would create a
"moral hazard" problem, i.e., it would encourage future investors in
Mexico (or even other developing countries) to make riskier
investments than they otherwise would have made because they would
expect the U.S. government to again come to their rescue should
another Mexico-like crisis threaten. Creating this perception on the
part of investors, critics alleged, could make future Mexico-like
crises more likely.
Second, some people questioned whether the spread of Mexico's crisis
to other emerging market economies posed a substantial threat to
those countries or to U.S. investors in those countries. Some
critics asserted that the spread that did occur was a temporary
market overcorrection that would have reversed itself before it
seriously harmed U.S. investors or other emerging market economies.
Others contended that the effect of the spread was an appropriate
market correction: financial markets had underestimated the risks of
investing in certain countries and thus had overinvested there in the
first place. Finally, some critics of U.S. financial assistance to
Mexico asserted that the threat a Mexican government default on its
short-term debts posed to U.S. trade, employment, and immigration
was not sufficiently great to justify financial assistance from the
U.S. government.
TERMS AND CONDITIONS OF U.S.
ASSISTANCE PACKAGE
---------------------------------------------------------- Chapter 4:6
On February 21, 1995, the United States and Mexico entered into four
financial agreements that would provide Mexico with up to $20
billion--the framework agreement, the oil agreement, the Medium-Term
Exchange Stabilization Agreement (medium-term agreement), and the
Guarantee Agreement, which are collectively referred to as "the
agreements." The agreements provide that ESF resources are to be made
available to Mexico in the form of short-term swaps, medium-term
swaps, and securities guarantees. They are to be used to assist
Mexico in stabilizing its exchange rate and financial markets by
facilitating the redemption, refinancing, and restructuring of
Mexico's short-term debt obligations. Under the agreements, the
provision of these resources is conditioned upon Mexico's
satisfaction of certain economic, monetary, and fiscal conditions,
including compliance with the IMF program that is outlined later in
this chapter, as well as reporting requirements.
THREE ELEMENTS OF THE U.S.
ASSISTANCE PACKAGE
-------------------------------------------------------- Chapter 4:6.1
The framework agreement provides that the United States will enter
into short-term swap transactions, with maturities up to 90 days and
in an aggregate amount up to $9 billion, through either the resources
of ESF or the resources of the Federal Reserve (backed by ESF) or
both. As part of the assistance package, the Federal Reserve agreed
to increase its swap arrangement with the Bank of Mexico to $6
billion until January 31, 1996. In exchange, the Treasury has
provided the Federal Reserve with assurances of repayment of any
drawings under the increased swap arrangement outstanding for longer
than 12 months. In these short-term swap transactions (and similarly
in the medium-term swap transactions), the United States and Mexico
are to exchange a specified amount of each other's currencies and
then reverse that transaction at a later specified date. The
interest rates applied to short-term swaps are intended to cover the
cost of funds to Treasury (or the Federal Reserve) and, therefore,
are set at the inception of each swap transaction at the then current
91-day Treasury bill rate. Short-term swaps may be rolled over after
90 days for a new 90-day period, at the new 91-day Treasury bill
rate.
Under the medium-term agreement, Treasury and Mexico may enter into
medium-term swap transactions, with maturities of up to 5 years, up
to an amount that when added to the amount of outstanding short-term
swaps and guarantees does not exceed $20 billion. Interest rates,
which are determined at the time of each medium-term swap
disbursement, are intended to cover the cost of funds to Treasury and
are set at a rate at least sufficient to cover the current U.S.
government credit risk cost for Mexico. For each medium-term swap
disbursement, the premium is to be the greater of (1) a rate
determined by the U.S. government's Interagency Country Risk
Assessment System (ICRAS)\10 as adequate compensation for the
sovereign risk of Mexico; or (2) a rate based on the amount of U.S.
funds outstanding to Mexico from short-term swaps, medium-term swaps,
and guarantees at the time of disbursement. This rate is between 225
basis points\11 (if $5 billion or less is outstanding) and 375 basis
points (if $15 billion or more is outstanding). Mexico is required
to maintain the dollar value of peso credits to the United States,
adjusting the amount of pesos on a quarterly basis, to reflect
changes in the peso-dollar exchange rate.
Finally, ESF funds may be used to guarantee the payment of all or
part of the principal of and interest on debt securities denominated
in U.S. dollars to be issued by the government of Mexico in an
amount that when added to the amount of outstanding short-term and
medium-term swaps does not exceed $20 billion. No guarantee may be
issued with respect to principal or interest payments due more than
10 years after the date of issuance of the debt securities. The
swaps and guarantees may be disbursed during a period of 1 year, with
an optional 6-month extension, after the effective date of the
framework agreement. Under the guarantee agreement, Mexico is to pay
to the Treasury Department a guarantee fee calculated using a present
value formula. The variables in the formula include the amount to be
guaranteed, the maturity of the debt securities, Treasury's borrowing
rate for the same maturity, Mexico's cost of borrowing with the
guarantee, and an appropriate credit risk premium, which is the
greater of the ICRAS premium, or 225 to 375 basis points, depending
on the total amounts of swaps and guarantees outstanding. As an
example, if the United States were to guarantee $8 billion of debt
securities issued by the government of Mexico, the agreement provides
for Mexico to pay the Treasury Department a guarantee fee of about
$1.9 billion.\12
--------------------
\10 ICRAS seeks to uniformly evaluate for the executive branch the
country risk contained in foreign loans and guarantees. Each year an
interagency committee devises uniform country risk interest rate
premiums for other countries. The Office of Management and Budget
requires executive branch agencies to calculate the costs of foreign
loans and guarantees using annually updated ICRAS ratings and country
risk interest premiums when foreign loans or guarantees are budgeted,
authorized, disbursed, or modified.
\11 A basis point is the smallest unit used in quoting yields on
bonds, mortgages, and notes. A basis point is equal to one
one-hundredth of one percentage point.
\12 This example assumes (1) a maturity for Mexican debt securities
of 10 years, principal repayment at the end of 10 years, and interest
repayment annually; (2) an interest rate on the debt securities of
6.5 percent per year, comprised of Treasury's cost of borrowing of
6.0 percent, plus a liquidity premium of 50 basis points to reflect
the fact that these securities would be less liquid than U.S.
Treasury bonds; and (3) a credit risk premium of 375 basis points,
assuming that, with the $8 billion guarantee, Mexico will have more
than $15 billion outstanding under the program.
THE OIL AGREEMENT
-------------------------------------------------------- Chapter 4:6.2
The oil agreement provides a source of repayment for support under
the assistance agreements. It sets forth the rights and
responsibilities of various parties as to the use of proceeds from
the export of crude oil and oil derivatives by PEMEX. It is to
remain in place until all of Mexico's payment obligations under the
assistance agreements have been fully satisfied.
The Bank of Mexico has established a special funds account at the
Federal Reserve Bank of New York as required under the oil agreement.
The amounts received by PEMEX into its private bank account in New
York, and credited to the special funds account, are to become the
property of the Bank of Mexico and the government of Mexico. With
respect to all exports that are not excluded under the agreements,
PEMEX is to irrevocably instruct its existing customers, and is
required to instruct new customers, to make all payments to the
account of PEMEX at the New York branch of a major international
bank. PEMEX is to instruct the New York branch of a major
international bank to transfer all payments to the Federal Reserve
Bank of New York special funds account within 1 business day of
receipt.
The Bank of Mexico is to authorize the Federal Reserve Bank of New
York to use the funds in the special funds account to repay all
amounts due and payable under the assistance agreements. Amounts may
be withdrawn by the Bank of Mexico when there are no amounts due and
unpaid. The Bank of Mexico and the government of Mexico are to
authorize the Federal Reserve Bank of New York to debit any account,
to liquidate investments, and to transfer all proceeds to a Treasury
account in the event that the Federal Reserve Bank of New York
receives a notice from Treasury that Mexico has failed to make any
payment under the assistance agreements. The oil agreement also
requires that PEMEX not export Mexican crude oil or oil derivatives
other than through a PEMEX entity and that PEMEX must cause any of
its subsidiaries that export crude oil or oil derivatives in the
future to become a party to the oil agreement. Finally, PEMEX is
required to maintain adequate insurance for all its businesses and
properties.
The oil agreement requires PEMEX to furnish Treasury with copies of
Securities and Exchange Commission reports, notices of default,
quarterly statements, and projections of crude oil and oil
derivatives exports, and whatever additional information that the
Treasury determines to be reasonably necessary. Furthermore, Mexico
agreed to notify and consult with Treasury in the event that, during
any 12-month period ending at the end of any calendar quarter, the
volume of crude oil exports is less than 85 percent and the dollar
value of the total amount of crude oil exports and oil derivatives
exports is less than 80 percent of the corresponding period in 1994.
After 5 years, these threshold levels are to be 75 percent and 75
percent, respectively. The purpose of the consultation is to assure
Treasury that Mexico continues to have the means to repay its loan
obligations from PEMEX oil and oil derivative export revenues should
that become necessary. If Treasury is not assured, Treasury and the
Mexican government need to agree on new terms that provide such
assurance. If Mexico and Treasury do not reach agreement after
consultation, Treasury can enforce mandatory prepayment provisions.
CONDITIONS PLACED ON MEXICO
-------------------------------------------------------- Chapter 4:6.3
The agreements placed several financial and economic conditions on
Mexico. The agreements provide that no funds may be made available
to Mexico unless Treasury determines that the resources of Mexico,
including oil proceeds, are adequate to assure repayment. To make
this determination, Treasury may require Mexico to provide
confirmation by independent public accountants that information in
quarterly reports as to export proceeds is consistent with the books
and records of PEMEX and its subsidiaries. Furthermore, the
framework agreement requires Mexico to provide to Treasury its
financial plan, and at least annual updates of the plan, during the
time that ESF resources are available. Before each request for
funding, Mexico must submit to Treasury a written description of
Mexico's financial developments, the intended use(s) of the proposed
funds, and how such use(s) are consistent with the financial plan.
No funds may be provided if Treasury determines that Mexico or the
Bank of Mexico has taken actions that are materially inconsistent
with the financial plan, the financial plan is materially
inconsistent with prevailing conditions, the intended use(s) are
inconsistent with the financial plan, or Treasury does not concur
with any material changes by Mexico to its financial plan.
Certain economic policy conditions also apply. For example, the
framework agreement provides that no funds will be provided if the
Treasury determines that Mexico and the Bank of Mexico's economic
policies are not in accordance with those economic policies approved
by IMF as part of its assistance program or if Mexico fails to
implement any of the economic policies announced by Mexico at the
time the agreements were signed.
ACCELERATION OF PAYMENTS
-------------------------------------------------------- Chapter 4:6.4
Under the agreements, Treasury may demand payment of any or all of
the swap obligations of Mexico, and require the defeasance\13 or
redemption of the guaranteed debt securities that are subject to
redemption, if Treasury determines that Mexico has failed to comply
with certain terms of the assistance agreements. However, certain
notice and grace periods apply to specified events of noncompliance.
For example, Mexico has 7 days to remedy the nonpayment of principal
or interest. If all amounts due are paid and all defaults are
remedied, Treasury may rescind its demand or requirement. In the
event of an acceleration of payments, early redemption of guaranteed
debt securities, or defeasance, the Treasury may distribute the funds
received as it deems appropriate.
--------------------
\13 In general, "defeasance," as contemplated by the guarantee
agreement, would involve the irrevocable deposit by the Mexican
government with the fiscal agent, in trust, or with Treasury or the
Federal Reserve Bank of New York, in trust, of government securities
or cash which, together with the earnings thereon, would be
sufficient to pay principal and interest of the guaranteed debt
securities when due.
OPTIONAL AND MANDATORY
PREPAYMENT
-------------------------------------------------------- Chapter 4:6.5
Mexico may, at any time, prepay any or all of its obligations under
the assistance agreements. Treasury may require Mexico to prepay its
swap obligations, defease the guaranteed debt securities, or redeem
debt securities upon its determination that Mexico has
"well-established access to funds on reasonable market terms." Mexico
is to provide to Treasury all the information that Treasury
reasonably requests to make its determinations.
ANALYSIS OF TERMS AND
CONDITIONS
---------------------------------------------------------- Chapter 4:7
OUR ANALYSIS OF RATES AND
FEES
-------------------------------------------------------- Chapter 4:7.1
In justifying the U.S. support package, Treasury officials stated
that the United States would be sufficiently compensated for any risk
associated with the financial assistance provided Mexico. The
specific interest rates applied to the short-term swaps are intended
to cover the cost of funds to Treasury and therefore are set at the
inception of each swap transaction based on the then current 91-day
U.S. Treasury bill interest rate. This is the same rate that the
Federal Reserve and Treasury charge other countries for short-term
currency swaps. As of August 1, 1995, the annual rate, adjusted
quarterly, for short-term swaps was 5.45 percent.
Mexico is to be charged a higher interest rate for medium-term
assistance at least sufficient to cover the U.S. government's
assessment of its credit rating. Interest charges, which are
determined at the time of disbursement on the medium-term swaps, are
designed to cover the costs of funds to Treasury plus a premium for
the risk associated with the extension of funds. For each
medium-term swap disbursement, the premium is to be the greater of
(1) a rate determined by the U.S. government's ICRAS to be adequate
compensation for the sovereign risk of Mexico or (2) a rate based on
the amount of U.S. funds outstanding to Mexico from short- and
medium-term swaps and securities guarantees at the time of
disbursement, which rate is between 225 basis points (if $5 billion
or less is outstanding) and 375 basis points (if $15 billion or more
is outstanding). The rates for medium-term swaps were 7.8 percent
for funds disbursed in March 1995, 10.16 percent for funds disbursed
in April and May, and 9.2 percent for funds disbursed in July.
A senior Treasury official told us that for two reasons the actual
risk to the United States may be less than the ICRAS premium. First,
the oil proceeds facility allows the United States to take proceeds
from the sale of exported PEMEX oil if Mexico defaults. According to
the official, the oil proceeds facility provides a strong incentive
for Mexican officials to take actions to avoid a default, since it
would be a politically sensitive issue if a point were reached where
the United States could start taking proceeds passing through the
facility. The official further noted that there has been a history
of successful loans to Mexico that made use of oil proceeds facility
arrangements. Second, in the official's analytical judgment there is
a reasonable expectation that Mexico's economic package will be
successful. This is important because a successful economic program
is needed if Mexico is to be capable of repaying the loans.
In circumstances such as the Mexican financial crisis, in which
financial markets essentially ceased to function in terms of Mexico's
access,\14 markets cannot be relied on to provide an accurate measure
of the risk. We believe that the use of the ICRAS rate as a starting
point, followed by adjustments, was a reasonable approach to
determine risk premiums.
--------------------
\14 According to Bank of Mexico data, for three successive weekly
auctions between December 27, 1994, and January 10, 1995, the number
of bids fell far short of the amount of tesobonos offered at auctions
for all maturities.
OUR ANALYSIS OF THE OIL
AGREEMENT
-------------------------------------------------------- Chapter 4:7.2
The oil agreement has been executed to help ensure that if Mexico
defaults on its obligations, the United States will be repaid both
principal and interest from oil export proceeds that PEMEX earns.
Proceeds from PEMEX's sale of oil to customers are to be deposited
into an account at the New York branch of a large international bank
and transferred to a special account at the Federal Reserve Bank of
New York under the terms of an irrevocable, acknowledged instruction.
The Federal Reserve Bank of New York, acting on behalf of Treasury,
has a right of set-off against these deposits if Mexico fails to make
interest and principal payments to the United States under the swaps
or the United States makes a guarantee payment. In Treasury's view,
the oil proceeds payment mechanism, while not ironclad, does provide
the United States with a high degree of repayment assurance and
represents an improvement over oil export facilities that had been
provided as assured sources of repayment for previous swaps with
Mexico.
An oil agreement has been an integral part of previous U.S.
financial assistance packages for Mexico. The United States has
never had to draw on oil proceeds in five previous agreements. For
each of these agreements, Mexico fully repaid all principal and
interest due. Treasury officials told us that the current oil
agreement is an improvement over previous oil agreements in that the
agreement, among other things, requires the flow of oil payments
proceeds through the account at the outset of the agreement;\15
allows Treasury to require mandatory prepayment of U.S. loans if
export volumes and proceeds fall significantly below 1994 levels;
includes irrevocable payment instructions acknowledged by PEMEX
customers; includes oil derivatives; and includes PEMEX's exporting
subsidiaries.
Another Treasury official told us that it would be difficult for
PEMEX to circumvent the oil proceeds facility. For example, he said
it would be difficult for PEMEX to order its customers to send their
oil payments elsewhere if the United States called for accelerated
prepayment. According to the official, PEMEX customers sent legal
notices to the Federal Reserve Bank of New York acknowledging the
irrevocable nature of the PEMEX deposit instructions. Thus, he said,
there would be legal barriers to the customers not doing what they
had agreed to do. If PEMEX were to cut off the customers who had
agreed to deposit their payments in the facility and instead sold the
oil on the spot market without having those proceeds transferred to
the Federal Reserve Bank of New York account, PEMEX would be in
violation of the oil agreement. This he said, would be a major blow
to U.S.-Mexico relations. Also, doing this would risk ruining
PEMEX's existing relationships with regular customers, and PEMEX had
gone to great trouble to create these relationships.
Finally, Treasury officials have pointed out that the coverage
provided by the funds flowing through the account over time is far
greater than Mexico's outstanding obligations under the agreements.
Treasury's assessment is based on 1995 oil export revenues (estimated
at $8 billion), market expectations of future export revenues, and
conservative U.S. interagency projections for future Mexican oil and
oil derivative export revenues. In addition, Treasury officials
noted that the oil export threshold mechanism as described above
provides an extra measure of protection against rapid changes in oil
prices or export volumes. In Treasury's view, while such changes may
affect the time needed to pay off outstanding obligations, Treasury
would be compensated through the application of late charges.
Whether the oil proceeds payment mechanism provides a high degree of
repayment assurance is difficult to assess because the facility
depends on future payments. The oil agreement amounts more to a call
on future payment flows rather than collateral in the traditional
legal sense. The oil agreement does not require a minimum balance
and, absent a default, proceeds are to regularly flow to an account
of the Bank of Mexico. The United States can stop disbursement of
additional loan payments to Mexico or can demand prepayment if Mexico
stops paying on its loans. Since the initiation of the agreement,
Treasury reports show that for each business day, approximately $25
million to $30 million has flowed into the account. Treasury
officials told us that about $6.8 billion flowed through the account
as of December 29, 1995. Under the terms of the agreement, money may
be transferred out of the account several times each day at the
request of the Bank of Mexico, and at most, a single day of proceeds
is likely to be in the account. Consequently, funds on deposit would
not be sufficient to cover a major nonpayment by Mexico. However,
the account could be used over time to pay off a default provided
that PEMEX continued to produce and export oil to the customers
covered by the agreement. Changes in the world price of crude oil
and petroleum products could affect the size of the deposits made and
thus the time that would be needed to pay off any major nonpayment.
Because of these uncertainties, in our view, the oil agreement by
itself cannot be considered as providing a high degree of assurance
that the United States will be repaid if Mexico defaults on its loans
or guarantees, but considered in the context of the agreements
implementing the assistance package, it does enhance the likelihood
of repayment.
--------------------
\15 In the previous agreements, funds did not flow into the account
unless Mexico defaulted.
OTHER TERMS OF THE
AGREEMENTS INCREASE THE
LIKELIHOOD OF REPAYMENT
-------------------------------------------------------- Chapter 4:7.3
In assessing the value of the oil agreement and the likelihood of
repayment by Mexico, the other terms and conditions of the framework
agreement must be considered. Under the framework agreement, Mexico
is to take actions to increase the likelihood that the United States
will be repaid for the swaps and securities guarantees. In the
framework agreement, Mexico agreed to meet stringent economic and
monetary policy conditions in return for U.S. and IMF assistance.
These economic conditions provide the United States and IMF with a
degree of influence over Mexican economic policy that did not exist
before the onset of the financial crisis in December 1994. The
agreements are to ensure that the U.S. and IMF will not lend if
economic and monetary targets are not being met, that the United
States can call for prepayment in certain cases of policy failure,
and that the United States will be alerted to policy changes. For
example, as a result of the stringent conditions and other factors\16
, Mexico's trade balance was transformed from a large deficit into a
surplus during the first 6 months after the framework agreement was
signed. This rapid turnabout has positive implications for Mexico's
ability to meet its debts.
The framework agreement also allows Treasury substantial discretion
in determining compliance by the government of Mexico. For example,
Treasury can determine whether Mexico has adequate resources to
assure repayment of funds drawn and whether Mexico has implemented
economic policies consistent with IMF's program. Furthermore,
Treasury may require Mexico to prepay, defease, or redeem its
obligations upon Treasury's determination that Mexico has
well-established access to funds on reasonable market terms. These
broad provisions require close monitoring, frequent consultation, and
timely information-sharing between Treasury and Mexico.
The Secretary of the Treasury and other U.S. government officials
have acknowledged a negative aspect of the package, in that it
entails government intervention in the functioning of financial
markets. They have concluded, however, that the risks associated
with not acting on behalf of Mexico would have been greater than
those associated with the assistance package, given the
interdependence of the Mexican and U.S. economies and the possible
adverse impacts of the Mexican crisis on international financial
markets generally. Also, no orderly work-out solution appeared
feasible because of the difficulty of working with many creditors.
--------------------
\16 Other factors responsible for the trade balance reversal include
real depreciation, reduction in spending due to balance sheet
problems, and reduced access to international credit.
IMF ASSISTANCE PACKAGE
---------------------------------------------------------- Chapter 4:8
The second largest component of the assistance package for Mexico
comes from IMF. IMF assistance was designed to restructure Mexican
debt and was contingent upon several things, including Mexico's
reducing its current account deficit and its inflation rate. On
February 1, 1995, IMF announced an 18-month standby credit of $17.8
billion for Mexico.\17 IMF made $7.8 billion available immediately
after the announcement. IMF agreed to provide the remaining $10
billion to the extent that a proposed package from a group of
unspecified non-G-10 countries falls short of its $10-billion target.
In this event, the remaining $10 billion in IMF resources would be
made available to be drawn through mid-1996. According to an IMF
official, repayment of funds under the IMF assistance package must be
made within 3 to 5 years.
An IMF official told us that this is the largest loan standby
arrangement IMF has ever extended to one country, and the largest
standby arrangement that IMF has ever extended as a percentage of a
country's IMF quota, the subscription that member countries pay to
IMF. Current rules permit an IMF member to borrow an amount equal to
100 percent of its quota per year, with a cumulative limit of 300
percent, unless exceptional circumstances exist. Mexico's IMF quota
is about $2.6 billion. IMF's current potential lending to Mexico
under the assistance package is equivalent to about 688 percent of
its quota over an 18-month period, or 459 percent of its quota on an
annual basis. This is substantially higher than the limit of 100
percent of quota on an annual basis, which is the usual maximum.
According to an IMF official, Mexico had no outstanding borrowing
arrangements in place with IMF at the end of January 1995. Its last
credit facility was negotiated in May 1989. Drawings under that
agreement were completed on May 25, 1993. At the time of the current
Mexican crisis, Mexico still owed about $3.8 billion from the 1989
IMF loan arrangement but was fully up to date in its repayments.\18
--------------------
\17 IMF actually approved assistance for Mexico for up to special
drawing rights (SDR) 12.07 billion. SDR is a unit of account IMF
uses to denominate all its transactions. Its value comprises a
weighted average of the value of a basket of five currencies, of
which the U.S. dollar has the largest share.
\18 IMF borrowing arrangements are considered completed upon the
final drawing of resources by the borrowing country under the
agreement. The borrowing country typically begins repayment
installments before the last drawing and continues to make payments
on the remaining amount due after that time. Thus, payments can
still be due even though an IMF arrangement is considered completed.
TERMS AND CONDITIONS OF IMF
ASSISTANCE PACKAGE
---------------------------------------------------------- Chapter 4:9
IMF approved an 18-month standby credit arrangement for Mexico of up
to $17.8 billion. Of the total, about $7.8 billion was made
available immediately. The remaining $10 billion is to be provided
by IMF to the extent that Mexico seeks to draw more than the initial
$7.8 billion and to the extent that contributions of governments and
central banks fall short of the targeted amount of $10 billion. The
IMF standby credit arrangement is intended to complement other
external financing for Mexico.
An IMF official provided information on both the availability of and
repayment schedule for drawings under the IMF's standby credit
arrangement for Mexico. Repayments are to begin 3 years after the
date of each drawing, and repayment of each drawing is to be made in
eight equal quarterly installments. Therefore, each drawing is to be
paid in full after 5 years, and the standby credit arrangement is to
be paid in full 5 years after the date of the last drawing.
The IMF assistance package imposes a variety of economic policy
performance criteria on Mexico as conditions of lending. Some of
these criteria, such as foreign exchange reserves and domestic credit
expansion, are strictly quantified with quarterly review dates; if
these quarterly targets are met, IMF will continue to make funds
available to Mexico. Other measures, such as privatization revenues,
have "goals" or benchmarks with greater flexibility.
According to the IMF official we interviewed, IMF does not generally
specify "events of default" in its agreements with borrowers. IMF's
usual practice is to make "policy judgments" regarding potential
defaults. An IMF director may ask for IMF executive board review of
a borrower's situation if loan conditions are not being met. If a
borrowing country is slightly "off track," IMF may grant a waiver of
certain loan conditions. If a borrowing country is severely "off
track," IMF stops new lending and negotiates corrective policy
actions to bring the borrower back "on track." The borrower's
economic program is to be revised or restructured with IMF executive
board approval.
In September 1995, an IMF official said that there have been no
problems between IMF and Mexico, which he said seems to be ahead of
its agreed-upon economic program. Although Mexico may not need
additional IMF funds, it still has the right to draw under the
standby credit agreement.
We believe that the IMF package is especially important because IMF
is generally considered the lender of last resort to sovereign
countries. If Mexico fails to meet the terms and conditions of its
agreement with IMF, Mexico could find it especially difficult to
borrow from other lenders. Thus, Mexico has a strong incentive to
comply with the terms and conditions of the IMF agreement. Doing so
should increase the likelihood that the United States will be repaid
for the financial assistance it has provided to Mexico.
INTEREST RATES AND FEES IN
THE IMF ASSISTANCE PACKAGE
-------------------------------------------------------- Chapter 4:9.1
An IMF official explained that the IMF assistance package to Mexico
is priced at an "SDR interest rate" that is a weighted average of
interest rates on short-term (3-month) government securities of the
Group of Five countries (France, Germany, Japan, the United Kingdom,
and the United States). The weighting corresponds to the weighting
of the currencies of these countries in the SDR. The SDR interest
rate is adjusted quarterly and is applied to all drawings under the
standby facility. The SDR interest rate was about 5 percent per year
as of July 1995.
No liquidity or maturity premium, and no country-specific risk
premium, are added to the basic SDR interest rate. However, certain
adjustments are made to the basic SDR interest rate to cover IMF's
administrative costs, to account for "free reserves" (i.e.,
contributed capital and retained earnings), and to accumulate
reserves for problem credits. According to the IMF official, the net
effect of these adjustments makes the rate charged to borrowers
virtually equal to the basic SDR interest rate and somewhat higher
than IMF's average cost of funds.
IMF is charging Mexico a commitment fee of 0.25 percent on the total
commitment of $17.8 billion, less amounts drawn. This annual fee is
payable at the beginning of each year. IMF is also charging Mexico a
usage fee of 0.5 percent on the amount of each drawing. This fee is
payable at the time of each drawing. The IMF official said that
these fees, in addition to the other IMF terms and conditions,
provide incentives to Mexico to return to the private capital markets
as soon as possible.
IMF COLLATERAL AND CREDITOR
STATUS
-------------------------------------------------------- Chapter 4:9.2
An IMF official confirmed that IMF's assistance package to Mexico
requires no collateral or security interests; however, he said that,
in IMF's view, "The policy conditions provide collateral." IMF
typically lends on an unsecured basis because borrowing countries
generally have no collateral when they come to IMF for assistance.
The IMF official said that IMF's preferred creditor status is not a
legal right or condition, but rather an international convention and
generally accepted practice. IMF, for example, does not reschedule
its loans when a borrowing country restructures its other public and
private debt. This practice reflects its de facto preferred creditor
status.
According to the IMF official, no documents specify that IMF has a
preferred creditor status and, for example, the U.S. assistance
agreements with Mexico do not explicitly recognize IMF's preferred
creditor status. Furthermore, he stated that some IMF officials
expressed concern about the oil agreement between the United States
and Mexico, since IMF was lending Mexico 459 percent of its quota.
They believed that the United States would have a prior claim on a
significant portion of Mexico's cash flow in any future crisis
situation.
OTHER INFORMATION ON THE IMF
ASSISTANCE PACKAGE
-------------------------------------------------------- Chapter 4:9.3
Some observers have commented that Mexico might not need to draw
further on IMF's assistance package if it can borrow on better terms
elsewhere. An IMF official responded that the comment probably did
not refer to the IMF's interest rates and fees, which are lower than
the current rates for Mexico in the private capital markets, but
rather to other terms and policy conditions.
The IMF official said that IMF has a distinct philosophical approach
to its assistance lending, i.e., "it works with countries when the
markets have failed them." IMF does not attempt to compete with
private capital markets, but rather to provide support to stabilize
economic and financial conditions in countries and markets. This
approach reflects the basic purpose of IMF since its inception and
applies in the case of Mexico. The IMF official noted that the U.S.
government or other international organizations may have different
purposes in providing assistance to Mexico.
MEXICO'S ECONOMIC PLAN
-------------------------------------------------------- Chapter 4:9.4
After the international assistance package for Mexico was announced,
on March 9, 1995, the government of Mexico released a new economic
plan to address the economic crisis. The plan contains stringent
economic policy adjustments consistent with agreements reached with
the United States and IMF. Its goals, as stated by the Finance
ministry, are to restore financial stability, strengthen public
finances and the banking sector, regain confidence, and reinforce the
groundwork for long-term sustainable growth. Officials from the
Finance ministry told us that they recognized that the plan would
result in an economic shock for the country more severe than had been
anticipated in the initial Mexican response of early January. The
hardship includes high interest rates, negative economic growth, high
unemployment, and a significantly higher inflation rate. The Finance
ministry officials stressed that the government expected this pain to
be short-lived, as Mexico makes the economic adjustments necessitated
by the economic crisis and incorporated in the March 9 plan.
CONCLUSIONS
--------------------------------------------------------- Chapter 4:10
Under the terms of the U.S. assistance package, Treasury committed
ESF to a $20 billion facility composed of three mechanisms. The
Secretary of the Treasury concluded that the assistance package was
consistent with the IMF obligations of the United States on orderly
exchange rates and a stable exchange rate system. We concur with
legal advice that the Treasury Secretary secured that he had the
requisite authority to use ESF to provide such assistance to Mexico.
As of December 22, 1995, $13.5 billion had been disbursed, while
$11.8 billion remained outstanding.
Interest rates applied to short-term swaps are intended to cover the
cost of funds to Treasury and are based on the current 91-day U.S.
Treasury bill interest rate. Interest charges for medium-term swaps
are designed to cover the costs of funds to Treasury plus a premium
at least sufficient to cover the risk associated with the extension
of funds over a longer period. Medium-term funds disbursed in April
and May carried an interest rate of 10.16 percent, which included a
risk premium of 3.52 percent when compared to the average of market
bid quotations on actively traded 5-year Treasury securities (i.e.,
6.64 percent) during those 2 months.
The risk of nonpayment to the United States is further mitigated by
the oil proceeds facility, Mexico's agreement with both the United
States and IMF to achieve stringent economic policy conditions, and
the IMF's assistance package itself. Whether the oil proceeds
facility provides a high degree of repayment assurance is difficult
to assess because the facility depends on future payments. However,
the facility may provide an important incentive for Mexican leaders
to take actions to avoid a default, since it would be a politically
sensitive issue in Mexico if a point were reached where the United
States could start claiming proceeds moving through the facility.
Also, it could be difficult for Mexico to circumvent the facility
because PEMEX customers have acknowledged the irrevocable nature of
PEMEX deposit instructions, and PEMEX might be reluctant to
jeopardize established relationships with existing customers.
INITIAL IMPACT OF MEXICO'S
FINANCIAL CRISIS AND EFFORTS TO
RECOVER, INCLUDING THE
INTERNATIONAL ASSISTANCE PACKAGE
============================================================ Chapter 5
Despite suffering a traumatic economic crisis in 1995, Mexico has
shown signs of recovery, with financial assistance from the United
States and the International Monetary Fund (IMF). Mexico is using
international funds to help in its efforts to stabilize its economy.
Although the country was still in the midst of a severe recession in
August 1995, it showed some positive economic indicators. Notably,
the current account deficit for the first half of 1995 was reduced by
96 percent compared to the same period in 1994. In addition, Mexico
has begun to access international capital markets, with the
successful offering of several large bond issues during the summer
and fall--an indication that investor confidence may be returning to
Mexico. Nevertheless, the precarious state of the Mexican banking
system, which the government has taken a number of steps to bolster,
remains a concern. Despite the progress to date, Mexico still faces
many difficult challenges before its financial crisis can be
resolved.
MEXICO'S INITIAL ACTIONS IN
RESPONSE TO THE ECONOMIC CRISIS
---------------------------------------------------------- Chapter 5:1
In January 1995, the government of Mexico began to take action to
deal with the financial crisis. In response to the continued
pressure placed on the Mexican peso after its December 1994
devaluation, the government of Mexico announced a change in its
economic policies on January 3 with the introduction of a new
emergency economic agreement. An extension of earlier Pactos, the
agreement had objectives that included avoiding an inflationary
spiral caused by the devaluation and reestablishing investor
confidence to stabilize access to financial markets. The government
acknowledged that the devaluation would result in painful
consequences for the country, including a temporary inflationary
spike, a drop in real earnings, the postponement of important public
spending projects, and a temporary credit squeeze.
The Mexican government was not able to achieve the agreement's goal
of regaining stability in the financial markets, however. Some of
the government's economic projections incorporated in the agreement,
such as maintaining a current account deficit of $14 billion and
reducing the expected rate of GDP growth from 4 percent to 1.5 to 2
percent for 1995, were not viewed as credible by international
investors. As a result, the government plan did not stem the tide of
foreign investors leaving the Mexican market.
MEXICO'S ECONOMIC PLAN
---------------------------------------------------------- Chapter 5:2
On January 3, 1995, the government of Mexico; the Bank of Mexico; and
representatives of labor, farm, and business sectors signed the
Agreement of Unity to Overcome the Economic Emergency. This economic
austerity program was presented to IMF in Mexico's request for a
standby arrangement. In approving the standby arrangement, IMF
endorsed the Mexican government's austerity program.
Mexican officials determined that the January economic package was
not successful, however, because foreign investors continued to
withdraw funds from Mexico. On March 9, 1995, Mexico's Finance
ministry announced a new package of monetary, fiscal, banking, and
social measures that sought to restore financial stability,
strengthen public finances, assist the banking sector, regain
confidence, and reinforce the foundations for long-term sustainable
growth. The plan contains stringent economic policy adjustments
consistent with agreements reached with the United States and IMF.
The principal goals of Mexico's program, as stated by the Finance
ministry, were the containment of inflation and the reduction of the
current account deficit. However, the March economic plan was not
initially accompanied by a Pacto between the Mexican government,
business, and labor.
Officials from the Finance ministry told us that they recognized that
the plan would result in an economic shock for the country more
severe than had been anticipated in the initial Mexican response of
early January. The economic hardship to date has included high
interest rates, negative economic growth, high unemployment, and a
significantly higher inflation rate. One Finance ministry official
stressed that the government expected this pain to be short-lived, as
Mexico made the economic adjustments necessitated by the economic
crisis and incorporated in the March 9 plan. Elements of the plan
are as follows.
MONETARY POLICY
-------------------------------------------------------- Chapter 5:2.1
The March 9 plan stated that through its new monetary policy, Mexico
would attempt to focus on stabilizing the exchange market. As a
result, domestic credit would be severely curtailed through tightened
monetary policy and increased financial regulation on the part of the
Bank of Mexico. The Mexican money supply would be cut 20 percent in
real terms.\1 The Bank of Mexico also established new reserve
requirements as well as limits on bank overdrafts, as a result of the
plan.\2
--------------------
\1 According to the Federal Reserve, Mexico's monetary program is
intended to target a particular growth rate of net domestic assets,
which, given flat net international reserves, would produce a
particular growth rate of the nominal monetary base. The extent of
real reduction in the monetary base then depends on inflation.
\2 According to the Federal Reserve, there is still no reserve
requirement on bank deposits. The Bank of Mexico has replaced a
system in which overdrafts had to be cleared on a daily basis with a
system in which commercial banks are required to hold a zero
cumulative reserve position with the Bank over a month-long period.
EXCHANGE RATE POLICY
-------------------------------------------------------- Chapter 5:2.2
The floating exchange rate policy would be continued. The March plan
projected that the exchange rate would be 6-6.5 pesos to the dollar
through 1995. The government planned to avoid any measures that
would limit currency convertibility. To facilitate the reduction of
risk in exchange market transactions and allow hedging against
peso/dollar fluctuations, (1) qualified domestic banks were to be
authorized to conduct futures transactions in pesos with customers
and on an interbank basis and (2) a parallel futures market at the
Mexican Stock Exchange and the Chicago Mercantile Exchange was to be
initiated.
FISCAL POLICY
-------------------------------------------------------- Chapter 5:2.3
The IMF program called for the Mexican government to continue to
strengthen its public finances. Selected fiscal policy measures were
stipulated as follows:
The value-added tax rate was to be increased from 10 percent to 15
percent.
Budgetary outlays were to be reduced by 1.6 percent of GDP for
fiscal year 1995.
Taxes on gasoline and diesel fuel were to be increased by 48.5
percent and electricity prices increased by 20 percent
immediately and 0.8 percent per month for the rest of 1995.
The fiscal surplus was to be increased by 2.1 percent of GDP.
BANKING POLICY
-------------------------------------------------------- Chapter 5:2.4
Measures to deal with the banking crisis were also announced on March
9, 1995. The International Bank for Reconstruction and Development
(World Bank), the Inter-American Development Bank, and other sources
agreed to provide resources of up to $3 billion to strengthen
Mexico's commercial banks. To ease growing domestic debt burdens
under Mexico's high inflation rates, financial authorities and the
Mexican Bankers Association put into place a loan restructuring
program with inflation-indexed units of account for small- and
medium-sized firms. In addition, Mexico's deposit protection agency
provided temporary capital to banks with short-term capital needs.
INCOMES AND SOCIAL POLICY
-------------------------------------------------------- Chapter 5:2.5
Mexico also made changes in incomes and social policy. Mexico
increased the minimum wage by 10 percent, in addition to a previously
announced 7-percent increase in wages. Because the two increases
were well below the projected inflation rate of 42 percent, the March
9 plan projected that there would be a decline in real wages. Health
benefits for unemployed workers were extended from 2 to 6 months, and
a rural employment program was instituted.
IMPROVED TRANSPARENCY
-------------------------------------------------------- Chapter 5:2.6
The plan also included a promise by Mexico that information on
foreign currency reserves and domestic credit conditions would be
announced on a weekly basis.
INITIAL ECONOMIC INDICATORS
SHOWED PROMISE FOR MEXICO
DESPITE CONTINUING HARDSHIP
---------------------------------------------------------- Chapter 5:3
The government of Mexico has drawn on the international assistance
offered by both the United States and IMF. According to the Treasury
December report, as of December 22, 1995, $13.5 billion in U.S.
funds had been disbursed to Mexico under the U.S. assistance
program. Of this amount, $11.8 billion remained outstanding: $1.3
billion in short-term swaps and $10.5 billion in medium-term swaps.
As of December 31, the United States had not extended any securities
guarantees to Mexico. Through the end of 1995, Mexico had not missed
any interest payments or required principal repayments under any of
the swaps. As of December 31, ESF had received $447.4 million in
interest payments from Mexico for short- and medium-term swaps, and
the Federal Reserve had received $46 million in interest on its
short-term swaps with Mexico. On January 2, 1996, $242.4 million in
interest was due to Treasury on the medium-term swaps; a Treasury
official confirmed that that interest payment had been received. In
early October, Mexico prepaid $700 million of the $2 billion in swaps
coming due October 30, anticipating the proceeds from a German
mark-denominated bond issue. Mexico had also drawn $13 billion from
IMF by the end of December 1995, none of which had fallen due or been
repaid.
In the first 3 quarters of 1995, Mexico had exhibited some positive
economic indicators that suggested the government's economic strategy
was meeting its initial objectives. The government's strategy relies
on a combination of unilateral economic adjustments combined with
policies that have been mutually agreed upon between the government
and IMF. As such, it is difficult to evaluate the direct effect of
the international assistance package on the Mexican economy.
Nevertheless, some of the initial indicators showed promise for
reaching the government's objectives. For example,
during the first half of 1995 the current account deficit was $620
million, a reduction of 96 percent in comparison with same
period in 1994 when the current account deficit was $13.8
billion;
at the end of August, the peso was trading at 6.3 to the dollar,
about 20 percent above the March 9 low of 7.45 to the dollar;
foreign currency reserves grew to $13.4 billion by August 18, up
from a low of less than $4 billion in January, based in part on
the capital flows from the international assistance package;
interest rates on short-term government securities (cetes) came
down from peak of 83 percent in March to 34 percent in August;
the inflation rate declined from a peak of 8 percent for the month
of April to 1.7 percent for August; and
90 percent of tesobonos outstanding at the end of 1994 were retired
by the government by the end of August 1995. (See fig. 5.1.)
Figure 5.1: Outstanding
Tesobonos, November 1994 -
February 1996
(See figure in printed
edition.)
Source: Government of Mexico.
However, more recent indicators demonstrate the difficulty Mexico
faces in making its economic adjustments. For example, Mexico's GDP
for the third quarter of 1995 was 9.6 percent lower than the third
quarter of 1994, indicating a deeper recession than the official
Mexican government forecast of 2-percent negative growth for 1995.
In addition, the value of the peso slid against the dollar in October
and November, closing at a low of 8.14 to the dollar on November 9,
1995. The peso has since regained some value, closing December 8,
1995, at 7.75 to the dollar. In response to peso volatility, the
government tightened credit, and interest rates on cetes rose to as
high as 60 percent in mid-November. Rates fell to 49.1 percent in
the December 18, 1995, auction. (See fig. 5.2).
Figure 5.2: Peso/Dollar
Exchange Rate, December 1, 1994
- November 16, 1995
(See figure in printed
edition.)
Source: Federal Reserve Board.
Finance ministry officials told us that at the end of 1994, the
Mexican people had very positive expectations about their future, so
that when the economic crisis hit, many were shocked and felt
deceived. Many did not understand why, after so much reform had
taken place, they would again have to face such hardship.
The government of Mexico has responded to the impact of the crisis by
taking measures such as allowing the minimum wage to increase and
raising producers' subsidies for bread, tortillas, and milk. In
addition, Finance ministry officials told us that the government
plans to implement programs to assist in worker training and to
provide rural relief. Nevertheless, real spending on social services
such as education, health, and potable water projects has declined,
according to a U.S. Treasury report.\3
Mexico's middle class, which had greatly benefited from Mexico's
recent economic reforms, has also been seriously affected by the
devaluation, in large part due to its accumulation of debt that is
either dollar denominated or that has floating interest rates,
according to U.S. embassy officials. A number of debtor relief
organizations have sprung up, putting pressure on the government to
respond. At the end of August, the government of Mexico announced a
new program to provide some relief to Mexican borrowers. The
Debtor's Aid Agreement set ceiling interest rates for debtors
carrying relatively low outstanding balances on their loans. For
example, credit card holders will pay 38.5 percent on the first $800
dollars they owe, with market interest rates applying to balances
higher than that level. Similarly, limits were also established for
corporate and personal loans. Borrowers who have been keeping up
with their payments are automatically eligible for the program, while
others are to have a grace period to renegotiate their loans.
--------------------
\3 The report notes that real spending for these categories has
declined less than for other government discretionary programs. See
Secretary of the Treasury, Monthly Report Pursuant to the Mexican
Debt Disclosure Act of 1995, (Washington, D.C.: June 30, 1995.)
INITIAL FINANCIAL INDICATORS
WERE POSITIVE
---------------------------------------------------------- Chapter 5:4
The cornerstone of Mexico's economic recovery may well be Mexico's
ability to reestablish the confidence of international investors. In
particular, Mexico must be able to reenter world capital markets to
help finance Mexico's recovery. Several financial indicators to date
suggest that investor confidence may be improving.
MEXICO HAS STARTED TO REGAIN
ACCESS TO INTERNATIONAL
CAPITAL MARKETS
-------------------------------------------------------- Chapter 5:4.1
Mexico has been able to return to the international capital markets
to restructure its short-term debt into longer-term obligations, a
positive sign that the government's strategy for financial recovery
may be accepted by international investors. On April 24, one of
Mexico's government development banks, Nafinsa, reentered the capital
markets by borrowing $170 million from a European bank at an interest
rate equal to the London Interbank Offered Rate (LIBOR)\4 plus 600
basis points, according to Nafinsa officials. They explained that
this was an important gesture because it showed that Mexico was back
in the market, and it might create some momentum. Both Nafinsa and
Bancomext, another Mexican development bank, have since been able to
access international capital markets.
The next significant step in returning to the international capital
markets for Mexico was the issuance of medium-term sovereign debt by
the government in July. The government of Mexico offered $500
million in floating rate, dollar-denominated notes with 2-year
maturities. The offering was oversubscribed, and the issued amount
was increased to $1 billion. The offering was led by Citibank,
Credit Suisse, and the Bank of Tokyo and the principal and accrued
interest of these notes may be converted into new capital in a newly
formed or existing Mexican bank or tendered as payment for shares in
any Mexican privatization. In August, Mexico did a second
international offering of 3-year, yen-denominated notes with a face
value of about $1.1 billion. (See table 5.1).
Table 5.1
Mexican Public Sector Bond Issuances,
May-November 1995
Issue Amount Interest
Issuer Type date (U.S.$M) Maturity rate
---------------------- -------- ------ -------- -------- --------
Bancomext Euro FRN May 23 $30.0 1 year LIBOR +
5.80%
Euro FRN May 31 $75.0 1 year LIBOR +
5.44%
Euro FRN June $300.0 2 years LIBOR +
144A\a 23 5.51%
Eurobond Oct. 2 �20 2 years 3%
billion coupon
(approx.
$200.0)
Nafinsa Euro FRN May 4 $110.3 1 year LIBOR +
3.50%
Euro FRN May 4 $73.7 7 months LIBOR +
2.25%
Euro FRN May 9 $50.0 1 year LIBOR +
6.00%
Euro FRN May 15 $28.0 1 year LIBOR +
8.00%
Euro FRN May 24 $10.0 1 year LIBOR +
5.60%
Eurobond Aug. DM250 3 years 10%
17 (approx. coupon
$170.0)
Eurobond Sept. SwFr150 3 years 7.50%
29 (approx. coupon
$122.0)
United Mexican Euro FRN Jul. $1,000.0 2 years LIBOR +
States 144A\a 20 5.375%
Euro Aug. �100 3 years 5%
MTN\ 17 billion coupon
(approx.
$1,100.0
)
Eurobond Oct. 5 DM 1 5 years 9.375%
(to billion coupon
settle (approx.
Nov. $700.0)
2)
Euro MTN Nov. $1,500 1 year Cetes -
30 (to 6% or
settle LIBOR
Dec.
5)
Eurobond Nov. �30 15 2.85%
30 (to billion months coupon
settle ($293.6)
Dec.
12)
Eurobond Nov. (to 2 years 3%
30 settle coupon
Dec. 12)
----------------------------------------------------------------------
\a Section 144A bond issues are private placements and not subject to
traditional disclosure requirements of other initial public
offerings.
Legend
DM = Deutschemarks
FRN = Floating rate note
LIBOR = London Interbank Offered Rate
MTN = Medium-term note
SwFr = Swiss Francs
� = Yen
Source: U.S. Department of the Treasury.
--------------------
\4 LIBOR is a key interest rate at which major banks in London are
willing to lend to each other. It is often used as a benchmark rate
in international financial transactions.
THE MEXICAN BOLSA HAS
STRUGGLED AFTER INITIAL
COLLAPSE
-------------------------------------------------------- Chapter 5:4.2
The peso devaluation and the subsequent loss of confidence by
investors had an extremely adverse impact on the Bolsa, as discussed
in chapter 2. After it reached a new low of 1,448 on February 27,
1995, the Bolsa demonstrated a significant recovery through August
1995. It had gained 36 percent in dollar terms by mid-June, on the
strength of the international assistance package and an improved
economic outlook for the Mexican economy as a whole. Further, the
Bolsa climbed through July and August, as the Federal Reserve lowered
U.S. interest rates. By September 8, after President Zedillo's
State of the Nation address, the Bolsa index stood at 2,622. It has
since fluctuated, sliding to 2,246 on October 27, 1995, then climbing
back to 2,655 on December 8, 1995.
In an effort to provide a more efficient market, Mexico is taking
steps to introduce new financial instruments that would modernize
Mexican financial markets. First, the Bolsa and the Chicago
Mercantile Exchange are developing distinct peso and interest futures
contracts to create a North American standard for futures trading for
pesos and Mexican Treasury interest rates.\5 A Bank of Mexico
official explained to us that the level of volatility in the peso
exchange rate is expected to decline with the addition of the peso
futures contract, so that international investors can hedge against
exchange-rate risk. An official from the Bolsa told us that Mexico
may gradually introduce other derivative\6 financial instruments,
such as warrants\7 on individual Mexican securities and options\8 on
individual Mexican stocks.
--------------------
\5 Peso futures contracts have been trading on the Chicago Mercantile
Exchange since April 1995.
\6 The market value of a derivatives contract is derived from a
reference rate, index, or the value of an underlying asset. The
underlying assets, rates, and indexes that determine the value of
derivatives include stocks, bonds, commodities, interest rates,
foreign currency exchange rates, and indexes that reflect the
collective value of underlying financial products. See Financial
Derivatives: Actions Needed to Protect the Financial System
(GAO/GGD-94-133, May 18, 1995).
\7 Warrants are certificates giving the owner the right to buy
financial instruments or commodities at a stated price for a stated
period or at any time in the future.
\8 Options are contracts giving their owner the right to purchase or
sell assets during a specified period at an agreed-upon price.
OTHER FINANCIAL INDICATORS
ALSO SHOW PROGRESS
-------------------------------------------------------- Chapter 5:4.3
Other financial indicators show that Mexico has made progress in
meeting its 1995 financial objectives. For example, the market for
Mexican Brady\9 bonds collateralized by U.S. Treasury bonds has
improved. Interest rate spreads\10 of these Mexican bonds over U.S.
Treasury bonds declined from 1,937 basis points in mid-March to 902
basis points by August 24, a decrease of 10.37 percent. According to
the November 30, 1995, Treasury report, interest rate spreads closed
November 1995 at 1,081 basis points. In addition, secondary
market\11 tesobono interest rates dropped from 30 percent in late
March to 8.5 percent by the end of August, a sign that investors were
assigning less country risk for Mexican investments.
--------------------
\9 Brady bonds, named after a former U.S. Treasury Secretary who
promoted their use, are long-term dollar-denominated bonds converting
international bank loans. Brady bonds are collateralized by 30-year,
zero-coupon Treasury bonds for bond principal value and a reserve
fund for interest payments.
\10 A spread is the difference between yields of securities of the
same maturity but of different quality.
\11 Secondary markets are exchanges and over-the-counter markets
where securities are bought and sold after the original issuance.
Proceeds of secondary market sales accrue to the selling dealers and
investors, not to the entity that originally issued the securities.
THE FINANCIAL CRISIS HAS ADDED
STRESS TO THE MEXICAN BANKING
SYSTEM
---------------------------------------------------------- Chapter 5:5
The government of Mexico's decision to devalue the peso in December
1994 placed additional stress on the Mexican banking system, which
had already been facing problems following privatization. Mexican
banks were privatized during 1991 through 1992, with the proceeds
exceeding $12 billion. However, Treasury reported that the buyers of
the banks paid on average over three times book value for their
acquisitions--a comparatively high price for the banks justified at
the time by their reputed strong profitability and high margins but
presumably requiring continued energetic performance. The buyers
also inherited loan portfolio problems that had accrued during the
period of government ownership, causing the percentage of overdue
loans in Mexican banks to climb well before the December 1994
currency devaluation.
After the devaluation, Mexican banks came under pressure in several
ways. First, many banks faced an immediate dollar liquidity problem
in January, because pesos continued to be converted to dollars and
foreign lenders were reluctant to roll over their dollar claims on
Mexican banks in significant volume, according to Treasury. Second,
the banks' capitalization levels were negatively affected by their
dollar-based obligations as the peso continued to decline against the
dollar. Third, banks' asset quality suffered as the percentage of
nonperforming loans continued to rise, reaching an estimated 11.9
percent of total loans by the end of June in the face of dramatically
rising Mexican interest rates.
MEXICO HAS TAKEN STEPS TO
HELP SOLVE PROBLEMS IN THE
BANKING SECTOR
-------------------------------------------------------- Chapter 5:5.1
The government of Mexico has taken a number of steps designed to help
the banking sector deal with the problems associated with Mexico's
financial difficulties. Several of these measures were initiated
unilaterally by the government of Mexico; others, designed to assist
the banking sector, were undertaken with the direct support of the
international financial community.
EFFORTS TO IMPROVE BANK
LIQUIDITY
------------------------------------------------------ Chapter 5:5.1.1
The Bank of Mexico, responding to the initial liquidity crisis among
banks in January, created a currency credit program through Mexico's
deposit insurance agency (FOBAPROA), to provide collateralized dollar
loans for banks that needed dollars to meet maturing obligations.
This FOBAPROA credit window was intended as a lender of last resort
and therefore charged an interest rate designed to reflect the high
dollar cost of these funds--25-percent interest. Nevertheless,
Mexican banks used the credit window extensively in the early months
of 1995, and total drawings reached a peak in mid-April of $3.6
billion. The drawings then declined to about $1.5 billion toward the
end of June as market conditions improved and have generally been
repaid since then.
BANK CAPITALIZATION
PROGRAM
------------------------------------------------------ Chapter 5:5.1.2
The government of Mexico has taken several measures to bolster the
capitalization of the Mexican banking system. In February 1995, it
launched the temporary capitalization program (PROCAPTE). PROCAPTE
is a voluntary program designed to assist banks that have
capitalization levels that fall below the internationally accepted
standard of 8 percent of risk-weighted assets. Officials from
Mexico's National Banking and Securities Commission explained that
PROCAPTE is intended for use by viable banks that are facing
short-term capital needs, rather than by problem banks that may
require intervention. Banks in the PROCAPTE program issue
subordinated debt,\12 purchased by the Bank of Mexico, in an amount
sufficient to raise their capitalization level to 9 percent. The
debt must be repaid within 5 years, or the Bank of Mexico will
convert the debt to equity and sell the equity in the private market.
In March 1995, six banks entered into the PROCAPTE program and issued
approximately $1 billion in subordinated debt. No additional banks
had joined the program through the end of September, although Banca
Serfin, Mexico's third-largest bank, was sufficiently recapitalized
to be able to leave the program at the end of June.
The government of Mexico undertook another measure to increase the
capitalization of Mexican banks by changing rules regarding foreign
ownership of Mexican banks. The United States and Canada negotiated
the opening of the Mexican banking system via NAFTA which, beginning
in 1994, allowed foreign banks to own up to 8 percent of the net
capital of the Mexican banking system. After the onset of the
financial crisis, Mexico amended its banking law to permit the
aggregate market share of foreign institutions to increase to 25
percent. As a result of these and other reforms, all but the three
largest Mexican banks--Banamex, Bancomer, and Banca Serfin--can be
acquired by foreign interests. In late spring, the Mexican bank
Probursa and the Spanish bank Banco Bilbao-Vizcaya reached an
agreement that the latter would increase its ownership share in
Probursa from 20 to 70 percent by a new capital infusion of $350
million.
--------------------
\12 Subordinated debt is repayable in a bankruptcy only after more
senior debt has been repaid.
EFFORTS TO ADDRESS ASSET
QUALITY PROBLEMS
------------------------------------------------------ Chapter 5:5.1.3
The government of Mexico undertook a series of measures throughout
1995 to address the increase in nonperforming loans resulting from
the peso's devaluation and the subsequent financial turmoil.
Recognizing the need to deal with the deterioration of asset quality
in the banking system at the onset of the financial crisis, Mexican
bank regulators implemented a more stringent system for maintaining
adequate loan loss reserves\13 in early 1995. Banks were required to
maintain either reserves for nonperforming loans of at least 60
percent, or reserves equal to 4 percent of the total loan portfolio,
whichever is larger.\14 Officials from Mexico's National Banking and
Securities Commission told us that they are receiving technical
assistance from several sources, including the World Bank, to help
strengthen their supervisory capability. In addition, they said they
have received a $1.7-billion loan to recapitalize the deposit
insurance fund of FOBAPROA, which will allow FOBAPROA to purchase
assets and resolve failing institutions more effectively.
The government of Mexico also created a new program to help banks
restructure portions of their loan portfolios to increase the
likelihood that loans will continue to perform in the face of high
inflation and interest rates. This program, the loan restructuring
program (UDI), essentially allows loan repayments to be stretched out
and weighted more heavily toward the end of the loan by denominating
loans in a UDI instrument that is linked to the consumer price index.
The borrowers repay a real rate of interest, while the real value of
the principal is preserved and amortized over an extended maturity.
According to Mexican officials, the program got off to a slow start
since its implementation in April due to the need to train both bank
personnel and borrowers on its operation and benefits.
--------------------
\13 Reserves are financial assets that banks must keep in the form of
cash and other liquid assets.
\14 The previous system gave Mexican banks discretion in classifying
their loan portfolios in five categories. Under this system, banks
created loan loss reserves based on requirements for each level of
classification. In December 1994, provisioning, or reserves, for
past due loans across all categories averaged 47.9 percent.
CHALLENGES TO MEXICO'S
EFFORTS TO RECOVER REMAIN
-------------------------------------------------------- Chapter 5:5.2
Notwithstanding the efforts of the government of Mexico to improve
bank liquidity, bolster the capitalization of the Mexican banking
system, and institute the loan restructuring program for banks, the
state of the Mexican banking system remains a concern. According to
a U.S. Treasury report issued at the end of December 1995, Mexico's
banking sector remains strained, with nonperforming loans still a
drag on the banking system. According to the Treasury report,
delinquent loans as reported by Mexico rose from a 1994 rate of 9
percent of all bank loans to about 17 percent of all bank loans by
the end of September 1995. However, Mexican banks define
nonperforming loans differently from U.S. banks. According to a
World Bank official, the 17 percent reported by Mexico would equate
to about 27 percent using U.S. generally accepted accounting
principles to calculate nonperforming loans.
Despite the progress to date, Mexico still faces many difficult
challenges before its financial crisis can be resolved. Interest
rates continue to be high. For example, the real interest rate on
28-day cetes in mid-November was about 20 percent. In addition, the
peso continues to be volatile, closing at a low of 8.14 pesos to the
dollar on November 9 before strengthening to 7.55 pesos to the dollar
on November 30. Economic growth for 1995, which was forecast at the
start of the year by the Mexican government to show a decline of 2
percent for the year, has been much worse. After declining
substantially in the first half of 1995, economic output in the third
quarter contracted by 9.6 percent from the same period a year ago.
Thus, it remains to be seen whether Mexico will be able to maintain
economic policies that will allow the economy to recover from the
crisis.
USE OF THE EXCHANGE STABILIZATION
FUND (ESF) AND FEDERAL RESERVE
RESOURCES
=========================================================== Appendix I
U.S. monetary authorities may use two sources of funds to stabilize
international currency markets: (1) ESF, which can provide loans,
credits, guarantees, and reciprocal currency arrangements (swaps);
and (2) the Federal Reserve swap network. Drawings on ESF and the
Federal Reserve swap lines generally involve short-term exchanges of
currencies through mutual purchases (i.e., swaps) with agreed-upon
buying prices, reselling prices, maturities, and interest rates for
the transactions. ESF swaps may be of longer duration. The purpose
and use of these resources have evolved since their inception due to
changes in the international monetary system. The Federal Reserve's
foreign currency directive states that
"system operations in foreign currencies shall generally be
directed at countering disorderly market conditions. . . .
Transactions shall be conducted . . . in a manner consistent
with the obligations of the United States in the International
Monetary
Fund. . . ."
The current statutory purpose of ESF is to promote a stable system of
exchange rates, consistent with U.S. obligations in the
International Monetary Fund (IMF). U.S. monetary authorities have a
history of using these resources to assist Mexico, with the
understanding that it is ultimately in the U.S. interest to promote
an orderly exchange rate system.
HISTORY AND OPERATIONS OF ESF
--------------------------------------------------------- Appendix I:1
ESF was established by section 20 of the Gold Reserve Act of January
30, 1934, (48 Stat. 337, 341) with a $2-billion appropriation. Its
resources were subsequently augmented by SDR allocations by IMF and
through its net income over the years. Income for ESF since then has
come from interest on short-term investments and loans, and net gains
on foreign currencies. ESF engages in monetary transactions in which
one asset is exchanged for another, such as foreign currencies for
dollars, and could also be used to provide direct loans and
guarantees to other countries. ESF operations are under the control
of the Secretary of the Treasury, subject to the approval of the
President.
ESF operations include providing resources for exchange market
intervention. ESF has also been used to provide short-term swaps and
guarantees to foreign countries needing financial assistance for
short-term currency stabilization. The short-term nature of these
transactions has been emphasized by amendments to the ESF statute
requiring the President to notify Congress if a loan or credit is
made to a country for over 6 months in any 12-month period.
PURPOSE OF ESF
------------------------------------------------------- Appendix I:1.1
ESF provides flexibility to respond quickly to unexpected
circumstances in international financial markets. Its purpose was
changed in light of developments in the international monetary system
during the 1970s. When the Bretton Woods system of fixed exchange
rates was ended in 1973, IMF no longer required member countries to
maintain fixed values for their currencies. To conform to this
change in IMF, the purpose of ESF was altered from stabilizing the
exchange rate of the dollar to other purposes consistent with U.S.
obligations in IMF regarding an orderly and stable system of exchange
rates.
ESF RESOURCES
------------------------------------------------------- Appendix I:1.2
No funds have been appropriated to ESF since its creation in 1934
but, by law, special drawing rights (SDR) received by the United
States from IMF have been allocated to ESF. ESF generates income
from interest on short-term investments and loans. ESF invests the
great bulk of its funds in highly liquid, high-quality U.S. and
foreign government securities and receives interest and fees from
loans to foreign countries. ESF has also had very substantial net
gains from activity in foreign exchange markets.
As of February 1995, total ESF resources available for lending were
approximately $25 billion equivalent. ESF dollar balances could be
enlarged, if necessary, through monetizing or selling special drawing
right certificates in the amount of SDR 1.5 billion and swapping some
or all of its yen and deutschmark balances. As of the end of January
1995, yen balances were valued at $11.9 billion, and deutschmark
balances were valued at $7.4 billion.
BACKGROUND OF FEDERAL RESERVE
SWAP NETWORK
--------------------------------------------------------- Appendix I:2
Operating as the U.S. central bank, the Federal Reserve participates
directly in international financial markets by undertaking foreign
exchange operations, most often direct operations in foreign exchange
markets. An additional component of these operations is the
reciprocal currency arrangement network, also known as the "Federal
Reserve swap network." The Federal Reserve established its first swap
arrangement with the Bank of France in 1962. It has subsequently
made similar arrangements with 13 other central banks and the Bank
for International Settlements (BIS).
PURPOSE OF FEDERAL RESERVE
SWAPS
------------------------------------------------------- Appendix I:2.1
Like Treasury's ESF, the purpose of Federal Reserve foreign currency
operations has evolved in response to changes in the international
monetary system. After the transition from the Bretton Woods system
of fixed currency exchange rates to the present system of flexible
currency exchange rates, the aim of the Federal Reserve's foreign
currency operations has been to counter disorderly conditions in the
exchange market through the purchase or sale of foreign currencies
consistent with U.S. obligations in IMF.
FEDERAL RESERVE
SWAP RESOURCES
------------------------------------------------------- Appendix I:2.2
At the end of November 1995, the Federal Reserve had standing swap
arrangements with the central banks of 14 nations and BIS. Resources
available in the Federal Reserve swap network with these countries at
that time equaled $35.4 billion. $3 billion of this $35.4 billion is
part of a $6 billion swap arrangement with the Bank of Mexico that is
available through January 31, 1996.
PAST U.S. FINANCIAL ASSISTANCE
FOR MEXICO
--------------------------------------------------------- Appendix I:3
HISTORY OF ASSISTANCE
------------------------------------------------------- Appendix I:3.1
The United States, through both ESF and Federal Reserve swaps, has a
history of assistance to Mexico dating back to the late 1940s.
Mexico is the only emerging market country that is part of the
Federal Reserve swap network. Mexico's inclusion reflects both the
close economic ties that the United States has with Mexico and the
importance of Mexico's economy for the United States. Until
implementation of the current assistance package, which made
available long-term ESF swaps, both ESF and Federal Reserve
transactions with Mexican authorities had been in the form of
short-term currency swaps, i.e., with an ultimate maturity of 12
months or fewer.
ESF ASSISTANCE
------------------------------------------------------- Appendix I:3.2
Mexico's original standing swap line with Treasury was established in
1941. Mexico drew on this line in the late 1940s and in 1965. In
1965, a $75-million reciprocal currency swap arrangement was
established between ESF and Mexico. Between 1980 and 1994, Mexico
drew on ESF six times, for amounts ranging from $273 million to $1
billion. Only one of these drawings was made on the standing swap
line--all the rest were made under ad hoc swap arrangements. Except
for a $600-million drawing in 1982, which was repaid in 11 months,
all drawings were repaid within 6 months.
FEDERAL RESERVE ASSISTANCE
------------------------------------------------------- Appendix I:3.3
The first FRS swap line with Mexico, initially valued at $130
million, was established in 1967. The size of this facility has
grown over the years. The original swap line was raised in 1973 to
$180 million, in 1975 to $360 million, and in 1979 to $700 million.
Then, in 1994, the amount was increased to $3 billion. This standing
$3-billion swap line became part of the North American Framework
Agreement--a trilateral swap facility between the United States,
Canada, and Mexico--in April of 1994. The FRS swap line with Mexico
is like the Federal Reserve swap arrangement with other central banks
in that it is reviewed and renewed annually. In addition to the
standing swap line with Mexico, there have been three ad hoc or
"temporary" FRS swap lines made available to Mexico to address
additional emergency needs since 1982. The most recent one was a
$1.5-billion temporary swap line, subsequently increased to $3
billion on February 1, 1995. The temporary swap lines generally are
not renewed.
Mexico has drawn on FRS swap lines to meet its temporary end-of-month
liquidity needs and to cover temporary shortfalls in its reserves,
while it was awaiting other assistance from IMF and the World Bank.
All FRS swap drawings by Mexico have been repaid in full by their
maturity dates and, in some cases, before their maturity dates.
U.S. ASSISTANCE FOR MEXICO
ALWAYS HAD SIMILAR
RATIONALES
------------------------------------------------------- Appendix I:3.4
According to U.S. government documents, Mexico drew on U.S. swap
lines in 1974 to alleviate a shortage of dollar reserves. Drawings
in the following 2 years were needed to counter financial market
pressure on the peso, which eventually led to a 40-percent
devaluation of the currency in August 1976. After Mexico sought
assistance from IMF, the United States provided additional drawings
as "bridge" facilities pending Mexico's receipt of IMF funding.
Rumors surrounding the economic policies of the Mexican President
later that year led to continued pressure on the peso and subsequent
drawings on ESF and FRS swaps. All of these drawings were repaid on
time.
The heaviest drawing activity by Mexico on United States swap lines
was in the early 1980s, surrounding the debt crisis of that period.
An untenable external debt burden led to new pressure on the peso and
another 40-percent devaluation in 1982. During the 1980s, Mexico had
five drawings on U.S. swap lines, three of which were part of
multilateral facilities with other countries.
CURRENCY SWAP OPERATIONS
------------------------------------------------------- Appendix I:3.5
In a swap transaction, two countries simultaneously agree to exchange
an amount of each other's currencies and to reverse that transaction
at a later date at a specified exchange rate. The initiating country
takes the currency it obtains, e.g., dollars, and uses it to finance
transactions to support its own currency. The country later acquires
dollars on the open market, which are used to "reverse the swap" by
paying back dollars to the United States. In a U.S. dollar swap
transaction, an initiating country agrees to pay interest on the
U.S.'s foreign currency holdings based on the 91-day Treasury bill
rate. Likewise, the United States pays a comparable rate on the
foreign country's dollar counterpart when it makes a drawing if these
dollars are invested in Treasury securities. Given the ESF's current
investment practices, there is no exchange rate risk to either party
in a currency swap, since the exchange rate at which the currency is
bought and sold is predetermined in the agreement. There is no
opportunity cost\1 or loss of income associated with swap
transactions.
In considering a request to initiate a swap, the United States seeks
assurance that the drawing country has a reasonable prospect of
prompt fulfillment of the swap arrangement terms. Such assurance
could include considering the foreign currency reserve levels of the
initiating country, or taking into account the prospective proceeds
or borrowings from international financial institutions such as IMF
or the World Bank.
(See figure in printed edition.)Appendix II
--------------------
\1 Opportunity cost is the cost of pursuing one course of action in
terms of the foregone return offered by the most attractive
alternative with the same risk.
COMMENTS FROM THE TREASURY
DEPARTMENT
=========================================================== Appendix I
(See figure in printed edition.)Appendix III
COMMENTS FROM THE FEDERAL RESERVE
SYSTEM
=========================================================== Appendix I
MAJOR CONTRIBUTORS TO THIS REPORT
========================================================== Appendix IV
GENERAL GOVERNMENT DIVISION,
WASHINGTON, D.C.
-------------------------------------------------------- Appendix IV:1
Allan I. Mendelowitz, Director
Susan S. Westin, Assistant Director
Curtis F. Turnbow, Assistant Director
Patrick S. Dynes, Evaluator-in-Charge
Wayne H. Ferris, Senior Evaluator
David T. Genser, Senior Evaluator
Philip J. Mistretta, Senior Evaluator
Kurt A. Burgeson, Evaluator
Michael A. Tovares, Evaluator
Rona Mendelsohn, Senior Evaluator (Communications Analyst)
LOS ANGELES REGIONAL OFFICE
-------------------------------------------------------- Appendix IV:2
Patrick F. Gormley, Assistant Director
Juan R. Gobel, Senior Evaluator
Anthony P. Moran, Senior Evaluator
OFFICE OF THE GENERAL COUNSEL,
WASHINGTON, D.C.
-------------------------------------------------------- Appendix IV:3
Sheila K. Ratzenberger, Assistant General Counsel
Rosemary Healy, Senior Attorney
GLOSSARY
============================================================ Chapter 1
BASIS POINTS
-------------------------------------------------------- Chapter 1:0.1
The smallest unit in quoting yields on bonds, mortgages, and notes,
equal to one one-hundredth of one percentage point.
BRADY BONDS
-------------------------------------------------------- Chapter 1:0.2
In the case of Mexico, bonds issued in seven different currencies as
part of a 1989-92 financing package for Mexico. Mexico's Brady bonds
consist of collateralized bonds with a U.S. dollar equivalent value
of approximately $30 billion maturing in December 2019. The bonds
are named after the former Secretary of the Treasury--Nicholas Brady.
Brady bonds are also issued by a number of other countries.
BRIDGE LOANS
-------------------------------------------------------- Chapter 1:0.3
Short-term credit extended in anticipation of longer-term financing,
most often arranged in conjunction with IMF and World Bank programs.
CETES
-------------------------------------------------------- Chapter 1:0.4
Short-term, peso-denominated Mexican treasury certificates.
COUNTRY RISK
-------------------------------------------------------- Chapter 1:0.5
Country risk is the risk that economic or political changes in a
foreign country--for example, lack of foreign exchange reserves--will
cause delays in payments to creditors, the imposition of exchange
controls, or even the repudiation of debt. Country risk is broader
in scope than sovereign risk in that it takes into account the
probability of debt repayment by private borrowers as well as central
governments.
CREDIT RISK
-------------------------------------------------------- Chapter 1:0.6
Risk that a borrower will not pay an obligation as called for in an
agreement and that the borrower may eventually default on the
obligation.
CURRENCY SWAP
-------------------------------------------------------- Chapter 1:0.7
An agreement to simultaneously exchange, buy for spot and sell for
future delivery, one currency for another at agreed-upon exchange and
interest rates, with the currencies being returned to their original
owners at a specified future date.
CURRENT ACCOUNT
-------------------------------------------------------- Chapter 1:0.8
This is the broadest measure of a country's international trade in
goods and services. Its primary component is the balance of trade,
which is the difference between merchandise exports and imports.
EXCHANGE RATE POLICY
-------------------------------------------------------- Chapter 1:0.9
A government's policies concerning the price at which its currency
can be converted into another.
EXCHANGE STABILIZATION FUND
------------------------------------------------------- Chapter 1:0.10
Currency reserve fund of the U.S. government employed to stabilize
the dollar and foreign exchange markets. ESF is managed by the
Treasury. The Federal Reserve Bank of New York acts as fiscal agent
for Treasury. ESF holds special drawing rights allocated to the
United States by IMF.
EXCHANGE RATE RISK
------------------------------------------------------- Chapter 1:0.11
The possibility that the value of a foreign currency will be
diminished due to unforeseen changes in foreign currency exchange
rates.
EUROBONDS
------------------------------------------------------- Chapter 1:0.12
Corporate or government bonds issued outside the country of the
issuer and denominated in a currency other than the currency of the
country in which the bonds are issued. Eurobonds are issued in
bearer form--payable to the holder. Various regulations may apply.
For example, if a bond is to be listed on an exchange, it must meet
the requirements of the exchange. The U.S. Securities and Exchange
Commission has regulations that must be complied with if an offshore
offering is to be exempt from registration. Borrowing in the
Eurobond market often makes it possible to obtain financing at lower
interest rates.
FOREIGN CURRENCY RISK
------------------------------------------------------- Chapter 1:0.13
See Exchange Rate Risk.
FOREIGN DIRECT INVESTMENT
------------------------------------------------------- Chapter 1:0.14
Foreign direct investment occurs when citizens of one nation purchase
assets in some other nation that give them managerial control of
economic activities related to those assets.
FOREIGN PORTFOLIO INVESTMENT
------------------------------------------------------- Chapter 1:0.15
The purchase by one country's private citizens or their agents of
marketable noncontrolling positions in foreign equity and debt
securities issues by another country's private citizens,
corporations, banks, and governments.
FOREIGN EXCHANGE
------------------------------------------------------- Chapter 1:0.16
Foreign exchange is currency used in the settlement of international
finance and trade between countries.
FOREIGN EXCHANGE MARKET
------------------------------------------------------- Chapter 1:0.17
The foreign exchange market is an interbank or over-the-counter
market in foreign exchange that is a network of commercial banks,
central banks, brokers, and customers.
FOREIGN EXCHANGE RESERVES
------------------------------------------------------- Chapter 1:0.18
The stock of official assets denominated in foreign currencies held
by the monetary authorities (finance ministry or central bank).
Reserves enable the monetary authorities to intervene in foreign
exchange markets to affect the exchange value of their domestic
currency in the market. Reserves are typically part of the balance
sheet of the central bank and are managed by the central bank.
Reserves are generally invested in low-risk and liquid assets--often
in foreign government securities.
FOREIGN EXCHANGE RISK
------------------------------------------------------- Chapter 1:0.19
See Exchange Rate Risk.
FORWARD MARKET
------------------------------------------------------- Chapter 1:0.20
A market where dealers agree to deliver currency, financial
instruments, or commodities at a fixed price at a specified future
date.
FUTURES MARKET
------------------------------------------------------- Chapter 1:0.21
A market where futures contracts are traded. Futures contracts are
negotiable contracts to make or take delivery at an agreed-upon price
of a standardized amount of a commodity or financial instrument
during a specified month.
GROUP OF TEN
------------------------------------------------------- Chapter 1:0.22
A group of 11 major industrial countries, members of IMF, that
participate in IMF's General Arrangements to Borrow and that consult
on general economic and financial matters in various forums. The 11
are Belgium, Canada, France, Germany, Italy, Japan, The Netherlands,
Sweden, Switzerland, the United Kingdom, and the United States.
LONDON INTERBANK OFFER RATES
------------------------------------------------------- Chapter 1:0.23
Key interest rates at which the major banks in the London interbank
market are willing to borrow funds from each other at various
maturities and for different currencies. It has become the most
important floating rate pricing benchmark for loans and debt
instruments in the global financial markets. These rates are
published daily by the Bank of England and are based on a sampling
from a group of reference banks that are active in the Eurocurrency
market, but agreements that use LIBOR do not necessarily rely on
quotes published by the Bank of England.
MARKET RISK
------------------------------------------------------- Chapter 1:0.24
The risk that a financial instrument will vary in price as market
conditions change.
MACROECONOMIC POLICY
------------------------------------------------------- Chapter 1:0.25
Macroeconomic policy concerns a nation's economy as a whole
including, among other things, price levels, unemployment, inflation,
and industrial production.
OPPORTUNITY COST
------------------------------------------------------- Chapter 1:0.26
The cost of pursuing one course of action in terms of the foregone
return offered by the most attractive alternative of equivalent risk.
PORTFOLIO INVESTMENT
------------------------------------------------------- Chapter 1:0.27
Investment in marketable debt and equity securities. Unlike direct
investment, it does not seek managerial control.
SET-OFF CLAUSE
------------------------------------------------------- Chapter 1:0.28
Set-off clauses give a bank a right to seize deposits at that bank
that are owned by a depositor or debtor for nonpayment of an
obligation to that bank.
SOVEREIGN DEBT
------------------------------------------------------- Chapter 1:0.29
The debt instruments of the central government of a country. Debt
instruments are typically bonds evidencing amounts owed and payable
on specified dates or on demand. Sovereign debt is not secured by
specific collateral but by penalties that creditors may impose on the
government--such as reduced access to financial credits, world
capital markets, or attachment of government assets.
SOVEREIGN RISK
------------------------------------------------------- Chapter 1:0.30
Sovereign risk is the risk of default by a foreign central government
or an agency backed by the full faith and credit of the government.
STANDBY CREDIT
------------------------------------------------------- Chapter 1:0.31
A letter of credit that represents an obligation by the issuing
organization to the beneficiary and that is contingent on the ability
of the beneficiary to perform under the terms of a contract.
SUBORDINATED DEBT
------------------------------------------------------- Chapter 1:0.32
Debt that is repayable only after other debt with a higher claim has
been satisfied.
SWAP
------------------------------------------------------- Chapter 1:0.33
See Currency Swap.
SYSTEMIC RISK
------------------------------------------------------- Chapter 1:0.34
Systemic risk is the possibility that failure of one or more
financial organizations or countries will trigger a chain reaction
and cause the collapse of other financial organizations or countries.
Systemic risk is the risk that a disturbance could severely impair
the workings of the financial system and, at the extreme, cause a
complete breakdown. A breakdown in capital markets could disrupt the
process of savings and investment, undermine the long-term confidence
of private investors, and cause turmoil in the normal course of
economic transactions.
TESOBONOS (BONOS DE LA
TESORERIA DE LA FEDERACION)
------------------------------------------------------- Chapter 1:0.35
Discounted, or zero-coupon, dollar-indexed, short-term obligations of
the Mexican government that are payable in pesos and, since late
March 1995, in dollars. They were auctioned on a weekly basis and
issued with maturities in multiples of 7 days--typically 28, 91, 182,
and 364 days. They have a face value of $1,000 U.S. dollars and are
book entry securities--that is, they are not available to investors
as certificates. They were issued at a discount, but the government
of Mexico could choose to make periodic interest payments. Banks can
contract with their customers to provide settlement in dollars at the
times they are repaid, but the authorities are under no obligation to
supply needed dollars to the banks. They are repaid on the date of
maturity to banks acting as brokers for their customers based on
average prices quoted by various foreign exchange dealers.
TRANSFER RISK
------------------------------------------------------- Chapter 1:0.36
The possibility that a foreign government may tax or restrict the
repatriation of earnings, capital, or foreign exchange. It is the
possibility that the value of an investment denominated in a foreign
currency will be diminished due to government-imposed regulations
restricting the ability to repatriate all or some earnings.
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============================================================ Chapter 2
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*** End of document. ***