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Mohamed Alahmadi Outlins Sep 28, 2016 Introduction; 1994 are the result of a balance of payments crisis that developed earlier during the year when a number of economic and political developments came together to disrupt its financing plans. A combination of events an increase in US interest rates, political ferment and presidential elections in Mexico, plus capital flight from Mexico which was prompted, in turn, by lax monetary policy during the last weeks of the Salinas administration all helped contribute to, and culminated in, a collapse of the peso at the end of 1994. A specialist in Western Hemisphere business and policy affairs, he has directed work programs for both the Council of the Americas and the Mexico -US Business Committee and has also been a journalist with Business Latin America. At present, conditions in Mexico are such that all actors in both the economic and political arenas are finding it necessary to redefine their roles vice versa one another, particularly as these changes in the system work themselves out under the Zedillo government. We make analysis to understand factors due to which crisis arises and the solution of those reasons so that in future such crisis may be handled with due care, following are the reasons due to which crisis arise; 1. How crisis arise; As investors buying the tesobonos are protected for a potential devaluation of the peso, the outflow of foreign currency stops, while the foreign exchange rate stabilizes. However, in November USD 3bn is pulled out of the country, of which USD 1.6bn on a single day (18 November). December 1st, 1994 The New Mexican government, ruled by President Zedillo, takes office. December 15th, 1994 The Wall Street Journal publishes an interview with the new Finance Minister Jaime Serra Puche, in which he disagrees that Mexico will devaluate the peso. Therefore, the Central Bank of Mexico declares a lift of the upper band of the exchange rate by 15%, an effective reduction of the peso. December 20-21th, 1994 In the two days after the declaration, USD 4.6 bn leaves the country, half of the overseas exchange reserves. December 22th, 1994 The interference on the foreign exchange market is elevated, and the peso is permitted to drift freely. 2. Dealing with the crisis; It would take Mexico years before inflation was at an acceptable level again. In the years after the self-governing debt and balance of payment crisis of 1982 the Mexican government moved to a more market orientated economic model. Only then, did banks and companies regain the option to borrow in financial markets abroad. Third, a managed exchange rate would help Mexico to fight domestic inflation After the nationalization of almost all private banks in 1982, Mexico privatized them again in 1991-1992. However, at that time the banking sector could be characterized as highly concentrated, with loans being primarily provided on the basis on political priorities rather than on credit worthiness. First, the government was mainly focused on maximizing the sales price with the restriction that foreign banks could not participate in the bidding process. To drive up the sales price the buyers were given considerable privileges the four central banks controlled 70% of all bank assets and the sector was almost closed to foreign competition. Second, the bidders' experience in the banking sector was not taken into account. Third, the Mexican government delayed the implementation of international banking standards. Another important feature of the banking sector was that the regulator was inexperienced in monitoring the banks and depositors had no incentive to monitor the banks, as the Mexican government guaranteed both deposits and liabilities. After the privatization of the banks, Mexico experienced an enormous credit boom, as all banks competed strongly to gain more market share to earn back their investments (table 2). Finally, banks borrowed in dollars to finance their expansion. In 1994, the FED raised its policy rate, causing a lower spread, as Mexico's central bank did not follow. However, a sudden stop of the inflow of portfolio investment in March through April, led to a considerable depletion of the foreign exchange reserves. 4) To stop the outflow of foreign currency in March 1994, Mexico's government started to issue short term dollar denominated debt, called tesobonos. The deterioration of the ratio of foreign exchange reserves to foreign denominated debt with a short maturity rate which started to concern investors. 5) In the year prior to the crisis, Mexico was confronted by social unrest. In addition, there were doubts about the fairness of the presidential elections of 1994. As explained above, Mexico's banking system was already in a bad shape prior to the crisis and the events in December according to Haber in 2005 was just the tipping point. Banks were therefore unable to honor their foreign currency liabilities. To prevent a systemic banking crisis, the government implemented a bailout program: 1) Providing dollar liquidity to the banks. 2) Allowing banks to transfer part of their 'bad' portfolio to the government, including NPL's. 3) Recapitalizing all banks, that did not have a minimal capital ratio of 8%. 4) The debt burden of borrowers was relieved. Loans could be converted to a CPI-index unit, whereby debtors paid a real interest of 4% plus a premium, which reflected the credit risk. Due to the measures, a collapse of the banking sector was prevented and no obligatory write-offs took place. It would however, take years for the banking sector to recover (table 2). Krueger states, \"As a consequence of illness of the banking sector, new credit was almost not available, exacerbating the economic crisis\" (Krueger and Tornell, 1999). How the crisis shaped Mexico is hard to tell, but there have been some structural breaks after the 1994 crisis. - In July 1997, the PRI, the political party that had been in control of Mexican politics for almost 70 years, lost the mayoral election of Mexico City. This could have been caused by the bad shape of the banking sector after the crisis. Another explanation could be that Mexicans are still reserved to take loans. - The Mexican peso remains freely floating, although during the Global Economic Crisis, measures were taken to prevent a large slide in the global economy. - The central bank has built up an adequate stock of foreign exchange reserves, currently representing 4.8 months of imports. The Mexican Tequila Crisis was triggered by a combination of poorly carried out reforms, a currency peg, current account deficits, policy rate hikes in the US, and social unrest. This finally led to both to have a currency and banking crisis. The banking sector, which was already in a bad shape, would have collapsed without the help of the government