The former Managing Director of the International Monetary Fund, Michel Camdessus, described the financial crisis that struck Mexico in 1994-1995 as ‘The First Crisis of the 21st Century’. The Great Seven industrial nations held another summit in summer 1995 to discuss, among other issues, Mexican-style crises and ways of preventing them. These concerns didn’t take long to materialize themselves. The crisis in countries of Eastern and South-Eastern Asia in 1997-1998 had many features in common. The largest nation of Latin America, Brazil, ended up in the orbit of a similar crisis in fall 1998. Finally, even though Russia has a special crisis many of its aspects resemble both the Mexican and Brazilian scenario.
Common features of 1990s crises
The then fashionable word ‘globalization’ can be taken as a starting point. Capital always tends to look for most favorable spheres of attraction worldwide. But before early 1990s there had never been such opportunities – political, economic, technical, informational. Only such islands as North Korea remain closed to foreign capital till today. Wishing to live by the rules of modern world and use its advantages, countries introduce full or at least substantial freedom for capital movement, import and repatriation (return to home country) of foreign capital, transfer of profits and interest home. At the same time, the global arena sees new players – countries of the second and third world whose banks and companies aren’t eager on complying with harsh financial discipline. Of course, developed countries also have quite a few problems but financial stability is a priority there. The situation in former socialist and new industrial nations is different.
This combination created the explosive mix which repeatedly detonated starting from mid 1990s in different countries and laid the foundations for the global economic crisis of recent years. The following processes are more or less uniform. The state collects taxes inefficiently and extravagantly spends money, quite often in the interests of corrupt bureaucrats. Budget deficits are covered by domestic and foreign borrowing. Since these loans give creditors high yields and are represented as ‘reliable’ the capital that expects a lucrative offer is integrated in government bonds. Desperately fighting for a place in global markets, companies take out loans from banks and end up incapable of repaying them after the slightest difficulty arises. Relatively weak national banks that have these non-repaid loans in their asset base draw funds from the global markets of capital by placing their bonds and getting loans. The currency and bank crisis evolves at the same time. Forced to pay a high interest on deposits and other types of resources, banks increase interest rates for loans they advance. Credit is out of range for many enterprises driving them to bankruptcy.
Trust is breached at a certain stage, foreign holders of public and other securities sell them massively, foreign banks demand repayment of credits. Economically, this means capital withdrawal from the country. Capital flight is accompanied by that of national companies, banks, individuals buying foreign securities and accumulating funds on foreign accounts. It is usual in crisis times that such processes evolve like an avalanche reaching panic levels. Capital withdrawal and flight from a country involves suddenly increasing demand for a foreign currency, there is a tendency for its appreciation and depreciation of the national currency. To maintain the currency’s exchange rate the country’s central bank should sell dollars or any other hard currency from its reserves. However, even large reserves appear insufficient, to say the least.
What has one left to do? One can devalue the currency simply by introducing a floating rate. One can ask for urgent loan support from the International Monetary Fund (IMF), European governments and American banks. One can do both – as usual. If that is impossible or insufficient, repayments of foreign debt are suspended, foreign holders of securities and other resources are denied conversion to a hard currency, a variety of currency restrictions are imposed. However, after that it is difficult to expect a high international financial rating and, as a result, access to global capital resources. This is what countries would pay any price to avoid.
Such crises leave the bank system in ruins, as was the case both in Russia and Indonesia. Some financial institutions are closed, others are taken over by strong national or foreign banks, the government is trying to help the third group by injecting budget money. During a crisis practically all countries faced a very complex issue of restructuring their banking systems.
The IMF is trying to find its place in the new global context. However, the Fund is a typical product of problems arising as early as in the first half of the 20th century. It was intended for lesser-scale and less comprehensive crises, mainly for elimination of temporary difficulties and stabilization of the current balance of payments where foreign trade is a determinant item. Deficits of foreign trade and other items of the current balance of payments can play a role, sometimes, substantial, in Mexican-style crises. But their major element involves forfeited trust and resulting capital flight that can lead to in large-scale problems. To fight this, the IMF has to build up its resources and credits which isn’t easy in itself. Besides, it insists that borrowing countries should take more drastic measures intended not only to eliminate foreign trade deficits, but also ensure financial stabilization in general. The Fund’s Missions sent to countries that have applied for its loans become increasingly meticulous and ask for economy, discipline, harshness from governments. The IMF transfers money owned by creditor countries headed by the US to borrowing countries. The Fund increasingly views loans given to creditors as throwing its money into a bottomless pit, while borrowers find the cure offered by the Fund increasingly more bitter. This meant an impending crisis of the International Monetary Fund itself.
Latin-American model of financial crises
Starting from 1930-40s vast countries rich in natural resources have been trying to drop the status of a raw materials producing appendage to the US and Western Europe and industrializing themselves by putting up import duties and other barriers from the rest of the world. Some results of such industrialization are enviable. For example, Brazil or, to be more precise, companies that implemented investment projects there. However, countries of Latin America and Russia have some aspects in common: they all have a cumbersome and inefficient public sector which burdens the budget and the banking system.Financial weakness is a chronic ailment of Latin America: taxes are collected poorly, tax evasion is rife, a substantial deficit of the state budget is commonplace. Capabilities for use of domestic savings to cover the deficit are rather limited. So, almost entire Latin America has been kind of a reserve of large inflation since the end of the Second World War. Brazil, Mexico, Argentina used to be large international debtors starting from the 19th century. After the war foreign debt of Latin American countries became an important element of the complex system of international debt. Their creditors include banks of North America, Western Europe and Japan, governments of a number of developed countries, a variety of institutional investors as well as international financial organizations headed by the IMF. As estimated in 1998, these three countries were in top ten of global debtors with Brazil coming first, Russia second, Mexico third and Argentina seventh in terms of debt amount.
In 1980 military regimes started going out of fashion in Latin America. An unsuccessful attempt to take away the Falkland Islands (Maldives) from England in 1982 served as the last impulse for Argentina. Mexico had closer ties with the United States and even became a member of the integrative group of the US and Canada. Brazil, it seems, simply got sick and tired of coups and juntas. In 1990, in the spirit of times, Latin American countries opted for the path of integration into global economy, denial of protectionism, reduction of administrative elements and development of market aspects of economy, privatization and liquidation of the bloated public sector. Bringing a number of advantages, however, this not only failed to eliminate chronic vices of economy but intensified them. Harsh winds of the global market appeared to be an insurmountable test for them time from time. In 1970s Mexico became a major oil exporter and started resting on its laurels, as a result. In 1980s lower global oil prices and higher interest payments for foreign debt drove Mexico to a crisis it had great difficulty in overcoming. In 1980s Mexico’s gross domestic product per capita fell a little instead of rising.
This decade was even less favorable for Argentina: the per capita product fell almost by 20% from 1980 to 1990. The country which traditionally used to hold one of the first places among developing countries in terms of the quality of life rolled back to the middle of the list.
Mexican-style crisis and ways of combating it in 1994-1995
The Mexican crisis is illustrative in two main respects. Firstly, given the condition of economy and finances of the country, there were no serious grounds to expect an outbreak of crisis. Neither international financial organizations, nor respectable analysts, nor foreign investors themselves were prepared for the crisis. Secondly, the crisis showed that relatively moderate political shocks can play a great role in undermining financial stability in conditions specific to chronically unstable countries. Mexican economy developed successfully in 1988-1993 and its positions worldwide strengthened. Long-lasting efforts finally succeeded and dampened inflation to one-digit annual figures (under 10% a year), while annual growth of gross domestic product averaged 3%. Mexico was among the countries most acceptable for foreign investments. By conducting privatization in the country and liberalization of international economic relations, Mexico seemed to have firmly stepped on the path towards healthy integration into global economy. Long-term foreign debt was restructured and had no immediate pressure on economy. Very important criteria of such progress included Mexico’s accession to the Organization for Economic Cooperation and Development (OECD) which meant a claim to transition to a group of developed countries.A top official at the Bank of Mexico (central bank) explained origins of the crisis despite such seemingly favorable conditions that “The crisis essentially was a result of a series of unpredictable political and criminal events…” An event of this kind, a mutiny of poor Indian peasants showed that the façade of Western democracy and economic progress conceals the rear of the multi-million rural population that could not use any blessings of civilization and was prepared to resort to arms in despair. A second event – assassination of the ruling party’s candidate running for Presidential elections. This revealed instability of the political system and a threat to revival of traditional terrorism and confusion it breeds. Further events didn’t support concerns of political collapse and the country’s return to the epoch of mutinies and insurrections. However, it was enough for foreign investors to see such concerns arise and they had great difficulty in reasonably establishing how realistic it was. However, without denying significance of these factors, independent experts point to reasons of the crisis closer to economy. A chain of factors usually occurring in countries of this type is top of the list.
People want to benefit from economic growth more and immediately or, if put scientifically, they are very prone to consumption and, as a result, rather prone to saving which causes imports to grow in the context of freedom of foreign trade. At the same time, the rise finds a reflection in growth of investments which enhances imports. As a result, Mexico developed a negative balance of foreign trade under current transactions worth 8-10% of GDP covered by inflow of foreign capital. Wellbeing depended on substantial and constant injection, primarily by foreign investors' acquisition of bonds of the central government, states and major national companies. One analyst noted that Mexico and foreign investors fell prey to kind of an illusion. The country that attained significant political and economic stability mechanically kept high interest rates that were one and a half times and more that of the average level in developed countries. Such a combination of moderate risk with increased yield drove managers in charge of investment funds of all types to add more Mexican securities to their portfolios. Especially given that they had good reason to do so because in 1994, in an attempt to attract foreign capital the government provided a dollar guarantee to buyers of its new bonds: if the national currency (peso) devalued they would be repaid the initial amount in dollars. Of course, a transition from issue of common peso-denominated bonds to issue with a dollar-denominated guarantee could serve as an alarm signal for investors but it wasn’t the case.
The Mexican peso neither was pegged to the dollar nor had a floating rate. Its rate was subject to the sloping corridor system rather similar to the regime of the Russian ruble rate before August 1998. Probably, a similar mistake was made here: the peso devalued at a rate slower than domestic inflation. As a result, the peso appreciated vis-à-vis the dollar in real terms. The overpriced national currency, as usual, held back Mexican industrial exports and stimulated imports. The market increasingly felt that the government and the Bank of Mexico would not be able to keep the exchange rate within the corridor and have to devalue it. By October 1994 all these factors got pieced together. Foreign capital started exiting Mexican securities; capital flight (i.e. sale of securities by investors and conversion of proceeds into dollars) exceeded the size of new issues which could still be placed given the dollar clause. The country’s foreign currency reserves more than halved between October and mid December 1994.
In mid December 1994 there was a moment of truth. Having no other resources to stop depletion of resources and capital flight, on 20 December 1994 the government announced its plans to raise the upper limit of the dollar corridor by 13%. This was perceived by the market and investors as an SOS signal. During the next day alone the central bank was forced to sell up to 6 billion dollars it held to meet demand from capital owners who were saving their investments in Mexico. Maintaining the new peso rate appeared impossible and by 26 December it fell by 36% as compared to the pre-crisis levels. The attempt to urgently place a large loan fell through. Fragile currency stability collapsed. Naturally, resignation of the Minister of Finance, as usual, became the first step as somebody should be held responsible for the crisis. Now the task was to stop the avalanche of the crisis and minimize its economic and political consequences.
To start with, it required that trust to the country, government, banks, currency be revived. The best path lay through joint and coordinated action of Mexico and the international community. In turn, this was possible only if the mainstream economic policy which could be described as liberal was maintained.
Economic disaster in Mexico strongly affected US interests. As early as in the beginning of January 1995 a package of guaranteed financial aid to Mexico was prepared amounting to 18 billion dollars, including 9 billion promised by the US government and 3 billion – by American banks. The remaining amount was promised by other countries and organizations. In the meantime, there were active negotiations under way with the International Monetary Fund. Eventually, by late February, they put together the largest package of international aid in financial history in the form of guarantees and a facility worth 52 billion dollars. The IMF took an unprecedented step and gave a loan 7 times exceeding Mexico’s quota while the common rule does not allow exceeding the threefold limit.
The point of this staggering amount which many believed excessive and, by the way, was not utilized in full by Mexico was exactly to show the entire financial world that the country would not be left alone to drown. Terms and conditions of this financial aid were traditional: cutting of the budget deficit, a comprehensive hold on inflation, limitation of bank credit, continued privatization, maintained convertibility of the national currency. 1995 turned out difficult for Mexico. Gross domestic product appeared more than 5% worse than in 1994 in real terms; industrial production fell about as much. Unemployment rates noticeably increased. However, the worst was not to come. They managed to keep inflation on moderate levels. As early as in late 1995 economic growth resumed and 1996-1997 was quite favorable for Mexico.
The so-called tequila effect, i.e. the financial hit on neighboring countries, occurred without ever bringing about a large-scale crisis in any of major countries of Latin America. Argentina faced most pronounced difficulties as the Mexican crisis caused a stock market collapse and depositor pressure on banks. The banking system was ‘cleared’ of weak banks. Eventually, up to 40% transactions ended up in the hands of large foreign banks that the population usually trusts more than local ones…
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