On the Thin Edge of the Wedge: Lessons Greece can learn from the Mexican Peso Crisis

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In 1994, Mexico went through a severe economic crisis. As the result of a violent series of socio-political incidents, the risk premium of the country increased, causing a sudden arrest in capital flows which in turn precipitated violent economic adjustments and exposed the inherent vulnerabilities of the Mexican Peso leading to an inevitable devaluation.  Amid widespread economic malaise, it was widely feared that Mexico’s government would default on its sovereign debt as it had done in 1982. Mexico, however, carried out monetary and fiscally restrictive policies in a very short time frame, enabling it to recuperate economic activity, strengthen macro-fundamentals, repay its creditors in record time and restore its credibility in international financial markets. Years’ later, Greece is facing a sovereign debt crisis of its own, caused by structural weaknesses in its economy, a crisis in confidence in the Greek government’s ability to pay-back creditors and the exogenous shocks caused by the Great Recession. Albeit there are many differences between the economic crises faced by both countries, there are important lesson that can be drawn from the Mexican experience, especially on how to regain market confidence in moments of intense financial turmoil.     

The Greek situation today, inevitably, has important differences with the situation faced by Mexico in 1994. The Greek economy today faces key structural deficiencies which lead to the current crisis; the Mexican crisis, meanwhile, was not caused by structural deficiencies as much as it was caused by an arrest in short-term capital flows. As a matter of a fact, Mexico had throughout the early 1990s undergone an ambitious program of reforms which had reduced barriers to entry, enhanced competitiveness, increased FDI and reduced the amount of State-owned industries. Thus, Mexico went into the 1994-5 crisis with a recently restructured economy. Greece on the other hand went into its crisis burdened by important structural rigidities: key assets remain owned by the State; there is an excessive regulative burden and several implicit barriers to entry such as excessive bureaucracy, corruption and opaque tax and labour regulations[1]. Mexico in 1995 faced inflationary pressures which required a restrictive monetary response; Greece suffers from deflation which would an expansive approach. These are only some examples of key differences between the crisis situations facing the two countries. Differences can also be cited in as much as the economies of both countries are concerned. For example, Mexico is an important exporting country, and its key commercial partner is the U.S; Greece, by comparison depends on imports and most of its trade is with the Eurozone.

There are however also amazing similarities between the two countries: both were late to develop and backward when compared with northern regional neighbours; both suffer from corruption and bureaucracy and have sizeable shadow economies which account for important amounts of unreported income; both have a relatively high statutory rate which falls entirely on an over-burdened salaried middle class, while the effective tax rate remains relatively low. Similarities can also be found on the experiences faced by Mexico during the 1994-5 crisis and that faced by Greece today. Both crisis saw economic overspending, current account deficits, a lack of access to international capital markets (and a loss of credibility therein), the possibility of a run on their external liabilities and banking crises.

The principle problem Mexico had to tackle in 1994 was overspending in the economy which had hitherto been financed by short-run capital inflows. In response, Mexico considerably tightened fiscal policy, thus achieving a balance of payment surplus of 4.7% in 1995, despite an economic contraction of 6%[2].  Mexico counted with political and social goodwill in order to implement significant, sometime painful austerity measures.

As time passed, it became clear that Mexico was facing the possibility of a run on its public and private external liabilities. Although key economic indicators budged for Mexico’s solvency, creditors quickly realized that if the roll-over of Mexico’s debt stopped, Mexico would be unable to finance its financial obligations. It was feared that Mexico would face a liquidity crisis similar to that suffered in 1982, when the government defaulted on its sovereign debt. In as much as Mexico was anxious to regain the credibility of international financial markets, they had to prove that the government would - through a consistent set of policies and without committing the past mistakes of: i) relying on inflationary financing and; ii) defaulting on its debt - manage to fulfill its obligations.

 

 

In order to carry this out, the government had to refinance its short term dollar-denominated public debt by $30 billion USD. In order to carry this refinancing out, Mexico sought a loan of $52 billion USD principally from the U.S Government and the IMF. Mexico was quick to accept the harsh conditions imposed on the loan - there was widespread political and social support for taking the steps necessary to restore the Mexican economy to health. Buoyed by the liquidity provided through the loan, Mexico was able to negotiate for creditors to roll-over maturing government debt. This measure restored credibility in the government and in Mexico’s commitment to pay all financial commitments. The result was that in a short time frame, the government and leading banks once again had access to international capital markets.

Finally, as a result of the shocks of the financial crisis, the over-indebtedness of corporations and households and an inherently fragile financial system, Mexico was facing a banking sector crisis. The government of Mexico decided to address the banking crisis as a fiscal problem, thus liberating resources which allowed the central bank to focus on the primary monetary policy goal of lowering rampant inflation. The objective of Mexico’s fiscal policy in terms of the banking crisis was to prevent a systemic run on the banks, combat moral hazard and strengthen the financial sector’s regulation and supervision while reducing the role of the central bank as lender of last resort for the abovementioned reasons. In line with these objectives, several measures were instrumented in this front. The Central Bank extended a dollar-denominated credit-line, with a penalty rate, to commercial banks so that they could fulfill their financial obligations; legal reforms were enacted to increase regulation and supervision while a program to capitalize the banks was set in motion. An example of how this capitalization was carried out is PROCAPTE. Through this mechanism, troubled banks created subordinated convertible debentures and sold them to FOBAPROA (the deposit insurance fund) with a 5-year maturity. In case the bank in question faced insolvency or was deemed to be mismanaged, the debenture would become equity which the government was expected to sell in order to avoid becoming a shareholder of a private bank.

 

In order to restructure the Mexican economy after the 1995 crisis and regain the confidence of international financial markets, Mexico did not rely solely on fiscal policy: they also made ample use of a restrictive monetary policy in order to tackle rampant inflation. After the painful peso devaluation, the government decided to dramatically increase interest rates (from 14% to 86%) and let the peso float. That meant that the fixed exchange rate would no longer be the nominal anchor of the economy and that monetary policy would now have to have a change in objectives; the central bank would no longer focus on defending a fixed peso rate, instead their sole objective would be inflation-targeting. The measure by any standard was a success: the economy quickly picked up, growing by 5.5% in 1996, while the stock market recuperated to its pre-crisis value and inflation dropped from 51.7% in 1995 to 12.3% by 1999.  

As we have noted, Greece does not suffer from inflationary pressures, rather from deflation. However, one can’t help wonder if having a much looser monetary policy wouldn’t be beneficial in reanimating the Greek economy. Perhaps, Greece should leave the Eurozone, let the drachma float (thereby regaining competitiveness) and have a monetary policy tailor made for its own pressing needs and not for those of other, more powerful European countries. The lesson to be learnt from Mexico is not in how to lower inflation, but in how having an independent monetary policy can be crucial in reanimating the economy and fixing macro-fundamentals. Greece can also learn from Mexico’s decisiveness: the fiscal and monetary policies narrated herein were instrumented in a very short time-frame and with remarkable political and social backing which is crucial in such circumstances. Thus, Mexico managed to calm markets and prevented a run on its external liabilities, while balancing the current account. Greece needs to implement a consistent and coherent strategy soon and enact it. There is a school of economic thought which says that when the music stops, a government must intervene quickly in order to avoid a long-drawn depression. If they were correct, Greece is barely now on the thin edge of the wedge: if its government doesn’t act quickly, it will indeed be the beginning of the end.

 

[1] IMF, (2013)  “Greece Selected Issues”

[2] Carstens, A. and Werner, A (1999), “Mexico’s Monetary Policy Framework under a Floating Exchange Rate Regime”, Banco de México, Documento de Investigación No. 9905.

 

References: 

Carstens, A and Werner, A. (1999), “Mexico’s Monetary Policy Framework under a Floating Exchange Rate Regime”, Banco de México, Documento de Investigación No. 9905.

IMF, (2013), “Greece Selected Issues” IMF Country Report No. 13/156

IMF, (2015), “Preliminary Draft Debt Sustainability Analysis”. IMF Country Report No. 15/165