1994 economic crisis in Mexico
Before the crisis, Mexico linked the peso to the dollar, but allowed a band within which it could float. The Mexican government would frequently have to intervene in the market to enforce this band. Mexico experienced a large trade deficit in 1994, perhaps indicating that the pegged peso was stronger than a peso would have been without government intervention. Money supply growth was brisk in the years preceding the crisis, and 20 percent or more per annum throughout most of 1994.
As always seems to happen in these types of systems, the Mexican government could not control the growing supply of pesos, nor could it bolster the weakening demand for pesos—while at the same time trying to maintain the peso’s value in terms of the dollar.
In December, the endgame began for this arrangement. Mexico’s central bank finally devalued the peso by 13 percent on December 20. By the end of December, the peso floated freely and fell another 15 percent. In the four-month period beginning on December 20th, the peso lost 50 percent of its value.
Mexico had nearly defaulted on its domestic government debt (in the form of tesobonos, mostly short-term debt instruments repayable in pesos linked to the U.S. dollar), until the country was bailed out by the International Monetary Fund and the U.S. Treasury; this form of debt was widely held by nonresidents.
The role of NAFTA
As a side agreement to North American Free Trade Agreement (NAFTA) in early 1994 was formed the North American Financial Group (NAFG), a mechanism to "stabilize" exchange rates between signatory countries. The NAFG supported the peso's exchange rate with a $6 billion line of credit. That kept the peso massively overvalued and enabled the Mexican central bank to rapidly inflate the money supply. This would presumably allow Mexico's ruling party to be victorious in the August 1994 presidential election.
U.S. investors were encouraged to place billions of dollars into Mexican stock and bond markets. The Federal Reserve had also stimulated this trend by pumping up the U.S. money supply while keeping interest rates low--driving U.S. investors into the riskier Mexican market in search of better returns.
After NAFTA was safely ratified, the Fed gradually raised interest rates, drawing capital back to the U.S. in a flight to quality. Without abundant foreign investment capital, the Mexican central bank was unable to service its foreign debt or finance its ballooning trade deficit.
Having depleted its dollar reserves, Mexico was forced to do what it should have done earlier: "un-peg" the peso from the dollar. When the market was allowed to function, the peso's value tumbled 50% from the level long dictated by Mexico City.
- Christopher Mayer. "The Failure of Fixed Rates", The Free Market, Volume 24, Number 1, January 2004. Also published here. Referenced 2011-06-28.
- Carmen M. Reinhart & Kenneth S. Rogoff. This Time Is Different: Eight Centuries of Financial Folly (pdf), Chapter 1 and Preface (pdf), see also the summary page. Referenced 2011-06-28.
- James Sheehan. "How Nafta Caused the Mexican Bailout", The Free Market, Volume 13, Number 7, July 1995. Referenced 2011-06-28.