In 1994 the interest rate increases due to the
recovery of Western economic. At that time, the political situation at Mexico
was unstable so lots of foreigner investors withdraw from their investments.
This lets Mexico lost lots of its foreign reserve holdings and it was running
out when the new president Ernesto Zedillo took over the position. Thus, the
government announced its decision to devalue the peso against the dollar by 14
percent to boost exporting. In other words, the Mexico government was trying to
reduce goods imported and prevent capital outflow. The following figure shows
that the account balance, net trade, and net income hit the lowest points in
Figure 1: The Account Balance, Net Trade, and Net
Income in 1994
In addition, we can also look at exchange rate for
Mexico and US from 1994 to 1995. We can know that the exchange rate was
decrease dramatically. People were restless buying large amount of US dollar
due to of Mexico’s decision for devalue.
Figure 2: The Exchange Rate for Mexico and US (1994-1995)
The main reason that led
to the difficulty of the balance-of-payments in Mexico is they use the inflow
of foreign capital to solve the balance of payments deficit. Mexico’s new
economic policy started in 1988, which did receive some effect. However, due to
the large differences in inflation between Mexico and the United States, the
exchange rate of the peso to the U.S. dollar has not been adjusted for a long
time, causing an overvalued currency. After participating in NAFTA, Mexico
imported much more rapidly than before, causing the trade deficit to rise. To
balance the current account deficit, Mexico borrowed heavily. due to the
situation has fluctuated, the government must use its foreign exchange reserves
to solve the decrease of foreign investment. The sudden drop in foreign
exchange reserves undermined support for domestic currencies, and the
government has to use currency devaluation to prevent foreign exchange losses
and finally cause the peso devaluation.
In order to prevented
or mitigated the balance-of-payments problem and the subsequent collapse of the
peso, there are several policy actions can be applied. Firstly, Mexico
should have more domestic saving which belongs to long-term investments rather
than rely more on short-term foreign capital investments. Secondly, limiting the
range of the frequency fluctuations in the nominal exchange rate. After Mexican
crisis, they used floating exchange rate, however, this lead to the serious inflation,
the unstable interest rates and the foreign exchange rate. Mexico needs to
develop the future exchange market, but this lead to the additional volatility
problems, so Mexico needs to set the highest and the lowest frequency fluctuation
for the nominal exchange rate. In addition, Mexico can improve the connection
with the International Financial Markets especially the norms of transparency. Transparency always helps prevent financial
crises. Besides, establishing a multinational safety net can help Mexico
prevent the peso crisis.
A multinational safety net must be established to safeguard the world financial
system from the peso-style crisis. No single country or agency can handle the
potential global crisis alone.
National financial transparency may help prevent financial crises. If they know
the real economic situation in Mexico, investors would be cautious to invent.
It may lead Peso gradually devalue, but would not collapse directly.
Mexico should do more saving instead of relying too much on foreign portfolio
investment to finance.
Mexico as a developing country, it should pay attention to the structure of
foreign investment. In 1993, about 80% of Mexico’s foreign investment of 30 billion
U.S. dollars was in the portfolio, while only 20% was direct investment. It led
two problems. One is increasing domestic consumption and less saving. The other
one is rising domestic inflation and overestimation of Peso, which hurt the
domestic trade balance.