Before the December 1994 devaluation, the Mexican government had essentially pegged the peso to the US dollar through its exchange rate stabilization program. Mexico permitted its exchange rate to fluctuate within a band of 2 percent. However, in December 1994 Mexico faced a balance-of-payments crisis. Investors lost confidence in Mexico’s ability to maintain the exchange rate of the peso within its trading band, in part because of Mexico’s large current-account deficit, which had reached almost \($28\) billion in that year. Intense pressure on the peso in foreign-exchange markets threatened to exhaust Mexico’s international reserves. This pressure eventually compelled the Mexican government to float the peso and led to the now-famous peso crisis between December 1994 and early 1995.

Exchange rate stabilization programs by developing countries are very difficult to pursue effectively over protracted periods. In programs such as that of Mexico, devaluation is not unusual, even when care is taken to address the typical problems by using exchange rate pegging as only a part of the overall program. After taking office on December 1, 1988, President Carlos Salinas used “pegging” as an important element of a broader program that included reduced government spending, tax reform, deregulation, privatization, and significant trade liberalization – including rapid reductions in tariffs and quotas through entries into the General Agreement on Tariffs and Trade (GATT), into the North American Free Trade Agreement (NAFTA), and into the Organization for Economic Cooperation and Development

(OECD). This broader economic program reduced the number of government-owned enterprises from 1,100 in 1987 to 220 in 1994, decreased inflation from 159 percent in 1987 to 7 percent in 1994, eliminated the nation’s budget deficit, increased exports to the USA by 35 percent, and cut wage increases in half between 1987 and 1994. The real sector of the Mexican economy was healthy, not sick.

The key, then, was not to balance the current account with the rest of the world, but to balance trade deficits with voluntary investment inflows. Mexico ran current-account deficits of \($25\) billion in 1992 and \($23\) billion in 1993, and during this time not only maintained the peso at around \($3.1,\) but accumulated large foreign reserves. In 1994, the current-account deficit was only slightly higher – \($27\) billion after 11 months. The problem came with the inflows, as political turmoil shook investor confidence.

The biggest shock came in March 1994, when presidential candidate Luis Colosio was assassinated. Ernesto Zedillo, who had been Salinas’s Planning and Budget Minister, was Colosio’s hastily selected replacement; he was elected in August as the new president.
Colosio’s killing, a year-long peasant rebellion in southern Mexico, and the September 1993 assassination of the ruling party secretary Francisco Ruiz had combined to weaken international investor confidence, while creating an image of Mexico as politically unstable. Consequently, foreign-exchange reserves had fallen from a peak of \($30\) billion before the Colosio assassination on March 23 to about \($12\) billion at the Zedillo inauguration on December 1 (see figure 4.7).
Mexico decided to devalue, widening the bands on the exchange rate on December 20 and going to a freely floating rate on December 22.

The latter decision was actually forced, because the earlier one collapsed as investor confidence in the peso disappeared. Widening the bands clearly presaged devaluation and led to a massive capital flight from the peso, and loss of \($6\) billion – or half of the remaining reserves – in one day. Judging by their public economic plans, the Mexican authorities had in mind an exchange rate of 4.07 pesos to the dollar, a 14 percent devaluation from the earlier 3.50 floor. But with confidence imploding, the peso dropped immediately to 5.80, a 40 percent devaluation (see figure 4.8).

Case Questions 1 Normally, economists suggest that exchange rate pegging by developing countries such as Mexico ought to be a temporary stabilization tool, ultimately followed by a managed float, a crawling band, or a floating exchange rate system. Briefly define each of these three exchange regimes.
2 Approximately \($24\) billion had fled Mexico in a run on the peso between April 1 and December 21, 1994. What is capital flight? How does it differ from capital flows? What were the major causes of capital flight in Mexico?
3 Explain the Mexican rescue package of \($50\) billion arranged by the USA and the International Monetary Fund to avert a broader financial crisis.
4 In making this unusual commitment (a \($50\) billion rescue package), was the world unintentionally rewarding Mexican mismanagement? What was to keep the same problems from causing another financial crisis that would require another rescue plan in the future?
5 Given all of Mexico’s problems, how risky was the US \($20\) billion aid package?

6 The home page of the International Monetary Fund (IMF), www.imf.org, provides IMFrelated news, their contracts, and an update on their most recent activities. Use this web page to find out about current IMF loans to its member countries.

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$ millions 30,000 Colosio assassination 25,000 Carpizo resignation threat Ruiz mass resignation 20,000 15,000 10,000 5,000 0 J F M A M J JASON D 1994 Figure 4.7 Mexican International reserves in 1994