Central Bank Autonomy in Mexico / Volume VI: A Difficult Takeoff
Author: Eduardo Turrent
Date: 2015-11-13T06:00:00+00:00
Publisher: Banco de México

Central Bank Autonomy in Mexico

A Historical Overview

Volume I

The Central Banking System in the World

Agustín Carstens

Governor

Roberto del Cueto Legaspi
Manuel Ramos Francia
Manuel Sánchez González
José Julián Sidaoui Dib
Deputy Governors

BANCO DE MÉXICO

EDUARDO TURRENT
Project supervision

AÍDA GARCÍA DIMAS
Historical research and project coordination

ANTONIETA CRUZ
Editorial coordination

ANTONIETA CRUZ
GERMÁN GÓMEZ
Iconographic research

NOSTRA EDICIONES
Editing, design, and prepress

SANDRA FERRER ALARCÓN
Graphic and editorial design

LUCERO VÁZQUEZ TÉLLEZ
ROSALINDA RESÉNDIZ PADRÓN
Graphic design

GREGORY DECHANT
Translation

MARÍA ESPERANZA ZOREDA LEE
Translation oversight

LIDIA CASTRO RAMÍREZ
Text transcription

LUIS EKIRO
GERARDO PEÑA TORRES
Banco de México images 2012

We would like to thank the following institutions for their support:
Sistema de la Reserva Federal
Banco Central de Chile
Centro de Estudios Monetarios
Latinoamericanos, CEMLA

Banco de México:
Oficina de Acervo Numismático
Subgerencia de Coordinación de Archivos
Subgerencia de Numismática y Comercialización

The reproduction of the images of banknotes used to illustrate the present work has been authorized by the Secretaría de Hacienda y Crédito Público (official authorization UBA/DGABM/1339/2005, dated November 2005).

First edition, 2012

All rights reserved

BANCO DE MÉXICO
Avenida Cinco de Mayo 2
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06059, México, D.F.

IEBN: 484-132-000005-28

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A Difficult Takeoff

Fatal Attraction

One success after another —concrete and visible, but also given masterful publicity through official propaganda and political action— marked the first five years of the six-year administration of Carlos Salinas de Gortari. The government’s achievements produced results on two fronts. First of all, they nourished the prestige that, gradually but without interruption, the new technocracy was earning in the rest of the world, as it opened Mexico up to prospects of development and progress that would have been unthinkable a few years before. At the same time, the figure of Carlos Salinas as statesman was growing to heights that would not be matched by any subsequent Mexican president.

The administration headed by Salinas continued to make all the right moves and then take the fullest political advantage of them. Although as a candidate, during the presidential campaign, Salinas had made some impressive statements and attracted the spotlights, it was only after he was sworn in that substantive progress began to take place. The first step was taken no later than the inaugural address of the young new president. Mexican public opinion was avid for hope and the inaugural ceremony did not disappoint. In his address, Salinas defined directions, proposed accords, identified needs and challenges, and called his government to “a further effort to achieve its central objective: raising living standards and expanding opportunities of welfare for all Mexicans.” At the culminating point of his address, the new president made this promise. “Our path toward change shall be nationalistic, democratic, and popular modernization.”[1]

President Miguel de la Madrid and Carlos Salinas de Gortari.

The repercussions of these successes were varied, but one phenomenon in the economic ambit is deserving of special mention: Mexico began to be an attractive destination for foreign investment, both direct and portfolio. As for the latter type, managers of large investment funds found themselves facing pressures of two kinds. First of all, they had to diversify their portfolios in order to dilute the risks inherent in financial investment. At the same time, the demands of investors who were depositing money in the funds led them to seek out more profitable investment options. At the time of its debt crisis, Mexico had become something of a pariah in the international financial community. But as a result of the cleanup carried out by the Salinas administration, things began to change, as the country put a whole range of investment options on the table. One alternative was the shares traded on the Mexican Stock Exchange, while another was the peso-denominated domestic public debt instruments.

A contributing factor was the exchange rate system in effect, whereby any change in the value of the peso against the dollar was announced in advance. Thus, the circumstances of predictable parity, much more attractive interest rates than those in the United States, and complete freedom of movement for capital were ideal for carry-trade operations. Institutional investors in developed countries —pension funds and investment funds— began to acquire large quantities of Mexico’s domestic public debt. A further attraction was the sheer variety of these securities, with treasury certificates (Cetes), development bonds (Bondes), adjustable federal government bonds (Ajustabonos), and federal treasury bonds (Tesobonos) —later to become sadly celebrated— all on the menu.

As a result of this massive acquisition through the secondary market of government securities by foreign investors, a singular phenomenon began to develop in Mexico. Although Cetes, Bondes, and Ajustabonos were denominated in pesos, the fact that foreign investors were holding them changed, if only implicitly, their financial nature. Time was to reveal the serious implications of this phenomenon, which had seemed innocuous at the beginning of the six-year administration of Carlos Salinas.

Still general director of Banco de México at the time, Miguel Mancera explained in a speech that as a result of the renegotiation of Mexico’s foreign debt, announced in 1989, capital inflows began gradually to pick up in the second half of that year. The fact was precisely registered in Banco de México’s Annual Report that year, without any clue to the magnitude the phenomenon would assume in the following years. In its 1989 report, the central bank briefly explained that the current account deficit of the balance of payments had more than doubled over the previous year. The 77% variation registered in the current account was simply attributed to the fact that the positive trade balance of 1988 had turned negative in 1989.[2] In essence, the situation was that, if capital inflows were showing up in a surplus of the capital account, the mirror image of this positive balance had to be a deficit in the current account of the same size, unless Banco de México was accumulating reserves and in this way re-exporting the capital.

The fact is that the significance of this deficit has not always been correctly evaluated. Some observers simplistically associate the existence of a deficit in the current account with a future increase of inflation. It is a fact clearly established by international experience, however, that in the initial stages of growth of countries with relatively low capitalization, investment needs and opportunities tend to exceed internal availability of savings, making it necessary to complement these resources with others from abroad. This translates into a current account deficit. Such has been the case of capital inflows. Such has been the case of countries with greater economic growth. Japan, for example, which is one of the main exporters of capital in the world today, still occasionally had recourse to foreign capital in the 1970s, and as a result its balance of payments showed a negative balance in the current account.[3]

The successes of the Salinist government continued, and with them the appeal of Mexico as a destination for foreign investors. In 1990, two more events gave an additional boost to this trend. One of them was the announcement that the Mexican government was negotiating a free trade agreement with the United States. Moreover, the privatizations being carried out by the government and the expected use to be made of the revenues generated by them had a very positive effect on public opinion both in Mexico and abroad. Former president Carlos Salinas has written that “one of the methods most often used by the Americans to harm their counterpart in the negotiation process was leaks to the media.”[4] This is precisely what occurred in March of 1990, when the Wall Street Journal published an article revealing that Mexico had for some time been in the process of negotiating a trade agreement with its northern neighbor and possibly with Canada as well. In order to save the project, the Mexican government had no choice but to announce the fact officially, with the result that negotiations could no longer be carried out in secret.

The other event was the privatization program of the Salinas government and its public impact. The administration always insisted that there was no ideological, limited-government motivation behind the privatizations. They were a way, on the contrary, of strengthening the government and through it the country. Behind this argument was the apparent paradox that a large government could give rise to a weak and vulnerable State. A fair and efficient State had to maintain itself at the right size to fulfill its responsibilities with speed and agility. Exactly the opposite happened when an oversized government meddled in areas that corresponded to the private sector. In particular, privatizations would make it possible to confront a parallel challenge: the government’s excessive domestic debt. According to Salinas, 29% of the revenues from the program came from the sale of the banks, 11% from the sale of Teléfonos de México, and the rest from other privatizations. All of the revenues were used to make advance payments on the domestic debt.[5]

The phenomenon of the capital inflows from foreign investment intensified in the course of 1989. Banco de México’s Annual Report of that year put a great deal of emphasis on the bolstering of confidence, to which the definitive renegotiation of the external debt had contributed significantly. Foreign portfolio investment was so large in 1990 that the authorities decided to include it as a separate item in the capital account. It accounted for almost US$2.0 billion of the US$4.6 billion in total foreign investment, contributing strongly to the US$8.8 billion surplus in the capital account. Banco de México explained that this surplus was used for two purposes: to finance more imports and to increase international reserves, which had grown by 49% since 1988. In its 1990 Annual Report, Banco de México insisted on the fact that the current account deficit had not been caused, as it had in the past, by public expenditures.

Net capital inflows in 1990 were fundamentally private in origin, since the net indebtedness of the public sector was negative, if external assets acquired to guarantee the renegotiated debt are taken into account. Thus, these inflows come from an increase in foreign investment into both the production of goods and services and the acquisition of portfolios on the Mexican securities market.[6]

The trends we have described intensified through 1991. Foreign portfolio investment increased by exactly 4.9 times over the previous year. The curious phenomenon was observed that portfolio investment accounted for 61% of total foreign investment in Mexico during the year, compared to 39% in more traditional direct investment, which involved decisions by foreign companies to install industrial plants and other productive units in the country. The capital account had also grown for other reasons, particularly the drop in foreign loans granted to Mexican companies. Ephemeral capital inflows had increased exponentially, but other indicators did not hit levels that caused concern among analysts and observers. Specifically, World Bank data showed that Mexico’s current account deficit in 1991 was at the reasonable level of 4.7% of GDP.[7]

Secretary of Commerce Jaime Serra Puche passes the documents of the North American Free Trade Agreement to President Carlos Salinas de Gortari for his signature.

What no one expected was how greatly capital inflows would increase over the next two years. In 1992 total foreign investment was up by almost 30% over the previous year. Already high in 1992 at 6% of GDP, the capital account surplus shot up to 6.6% of GDP in 1993. Although 1993 marked the high point, attention needs to be focused first on what happened in 1992. In that year, around two-thirds of the capital account surplus corresponded to foreign investment, while a further one-fifth could be accounted for by the debts of private companies, which, in spite of predictions to the contrary, were down by almost one-third from the year before. Two other relevant items were increased repatriation of capital, which had also grown unexpectedly in 1992, and a drop in the deposits of Mexican banks abroad.

In 1992, as also in the two previous years, the fundamental causal factor in the evolution of the external sector was the inflow of private foreign capital. This inflow was the result of several concurrent phenomena: the satisfactory performance of the Mexican economy, the bolstering of favorable medium and long-term expectations, and existing investment opportunities, both physical and financial. These favorable expectations are sustained by confidence in the economic program that has been implemented.[8]

In 1993 the capital account surplus of the balance of payments reached an unprecedented level: 6.6% of GDP. Monthly capital inflows through the first eleven months of the year had averaged approximately US$2.0 billion. In December alone, however, “once the uncertainty surrounding the ratification of the Free Trade Agreement had been eliminated,” inflows exceeded US$7.0 billion. What perspective was reasonable to expect for Mexico in a situation so highly appealing to financial operations and to business in general?

By this time the current account deficit was generating a certain amount of controversy not entirely free from concern. Public opinion had not been sufficiently informed that foreign capital inflows caused a surplus in the capital account of the balance of payments. Unfortunately, attention was focused exclusively on the deficit in the current account. A rather simplistic interpretation asserted that a current account deficit —especially a relatively large one— was an unequivocal sign of an overvalued currency. It is true that massive capital inflows tend to push up the exchange rate. In order to prevent this, however, the authorities had imposed a ceiling on the rate and allowed the central bank to accumulate large amounts of international reserves. The net balance of Banco de México’s international reserves had gone from US$6.9 billion in 1989 to US$18.5 billion in 1992, before increasing by almost US$6.0 billion more in 1993. What is more, as the country’s economic performance was seen to be more positive, it could be expected that capital inflows would continue to increase, along with the deficit in the current account. The argument was impeccable. In the event of conditions unexpectedly taking a turn for the worse, however, the entry of capital could suddenly drop off. In a worst case scenario, if the situation in Mexico were to deteriorate drastically, the capital that had already entered would look for a way out.

Miguel Mancera offered a wide-ranging reflection on the phenomenon of capital inflows and the lessons to be learned from the Mexican experience between 1988 and 1993. He began by referring to “a relatively novel financial phenomenon: the surge of capital inflows into emerging markets.” It was doubtless a salient feature, he continued, of the much more extended process of economic globalization. The Mexican government had embraced the globalization process and therefore had never considered the possibility of regulating or artificially controlling movements of capital. Also, although Mancera did not specifically mention this, its geographical proximity to the United States made it unfeasible for Mexico to implement such controls. Moreover, through its affiliation with the Organization for Economic Cooperation and Development (OECD), Mexico had decided to join the process of globalization.[9]

Economist Miguel Mancera has enjoyed a long career at Banco de México.

All over the world, even among those in favor of globalization and international movements of capital, the lack of sound, well-informed orientation was cause for concern. What is more, this could be said not only of individuals and institutions but also of the governments of countries which, at a given moment, had encouraged the rest of the world to free up international movements of capital. It was paradoxical that these individuals, institutions, and governments, although they were in favor of the free movement of capital, repudiated “some of the consequences of capital inflows, such as the growth of the current account deficits of receiving countries and the appreciation of real exchange rates.”

Mancera then offered a general panorama of the phenomenon of capital inflows to Mexico, which had begun in 1989 after the settlement with the commercial banks to restructure the country’s foreign debt. Thereafter, these inflows had increased rapidly through 1993. Thus, from January 1989 to the end of 1993, the accumulated surplus of the capital account was US$94.0 billion, compared to nearly zero in the period from 1983 to 1988. Around 66% of the 1989-1993 surplus was due to foreign investment, of which approximately 68% was portfolio investment. The growing foreign debt of the private sector accounted for the remainder of the surplus in the capital account.

With his accustomed expository skill, Mancera went on to explain what benefits could be expected from such an enormous injection of resources. The first advantage was that the availability of external savings in such large amounts had served as a complement to domestic savings for financing investment. In the 1989-1993 period gross fixed investment in Mexico had amounted to around US$400 billion, financed as follows: 29% through external savings (captured by means of surpluses in the capital account) and the remaining 71% through domestic savings. In other words, the resources captured through foreign direct investment, foreign portfolio investment, and private sector financing had been used to expand Mexico’s production capacity. Mancera concluded by declaring that the additional debt had not been misspent “financing unproductive expenditures.”[10]

Along with allowing higher levels of domestic investment, foreign capital inflows had offered benefits on three other fronts. First, it had made possible the modernization of Mexico’s production facilities, as old and obsolete installations were replaced by technologically advanced equipment and machinery. Another benefit was the preparation of companies to compete in world markets, with up-to-date capital goods that helped generate important gains in efficiency and productivity. Finally, the depth and magnitude of the investment had allowed Mexico to modernize its financial system. The intermediaries receiving these foreign inflows had been obliged to develop special operating skills to ensure the effective placement of resources.

Set against these undeniable benefits were certain inevitable costs. One important point was the interpretation formulated by investors, analysts, and governments in developed countries regarding the current account deficit which the capital inflows had naturally generated. The relative size of this deficit —almost 6% of GDP in 1993— sowed doubts about its long-term sustainability. Another concern was the way capital inflows were affecting the behavior of both individuals and companies, as budgetary restrictions were relaxed. The most serious consequence was that this relaxation of budgetary restrictions had greatly shrunk the availability of credit. The largest problem, however, was macroeconomic.[11] Given the intrinsic volatility of capital inflows, any abrupt change in their volume or, in the worst case scenario, a reversal of direction, would put Mexico’s domestic economic policies to a severe test. In the course of 1994 the country would have to face up to its vulnerability to this danger.

Foreign Exchange Collapse

Banco de México’s international reserves grew uninterruptedly during the first five years of the administration of President Carlos Salinas, as the country received an ever-increasing amount of foreign capital. Perhaps the capital inflows, and consequently the accumulation of reserves, would not have been possible at all, or would at least have been less, if the economic policy of the administration had not placed special emphasis on reducing inflation and reinforcing macroeconomic fundamentals. The price index moved downward every year between 1989 and 1993 and by 1995 inflation was at the very low rate of 5% annually. Another factor that doubtless contributed to the accumulation of international reserves was exchange rate policy. At the rates in effect, the supply of currency on the exchange market regularly exceeded demand, making it possible for the central bank to continue accumulating reserves.

We have referred to exchange rates, in the plural, because since December of 1982 the regime of partial exchange rate control in Mexico had given rise to a dual market. In November 1991 the government announced that this exchange rate regime would be terminated. Two important consequences followed: first, the disappearance of the controlled exchange rate and its substitution by a representative market rate; and second, a widening of the differentials between buying and selling. This second consequence made for a more efficient exchange market, without the intervention of the central bank, as the costs of exchange transactions were reflected more faithfully in market rates. Another important decision was to reduce the crawl of the exchange rate band from 40 to 20 centavos daily as of 11 November 1991. As a result, rates for liquidating obligations in foreign currency depreciated by 4.3%, significantly less than the 11.5% depreciation registered the previous year. The deviation of the crawling band for the interbank selling rate closed at 4.6%.

A floor and a ceiling for the exchange rate were established in November 1991, but it was only in October of the following year that the crawling band was put in place which would characterize the exchange rate regime all through 1993 and into the traumatic year of 1994. On 21 October 1992 the upper limit of the band was increased from 20 to 40 centavos, while the official floor remained constant at 3.052 Mexican pesos to the US dollar. The practical implications of this new regime were considerable. The basic idea was that the exchange rate would have an ever wider margin to adapt itself to changes in supply and demand. Meanwhile, as time went on, the country would move gradually to a floating exchange rate.

How could the proposal of a gradual progress toward a floating rate be reconciled with the function the exchange rate was fulfilling in the government’s anti-inflationary strategy, the so-called Pact that had been adopted at the end of 1987? It should be recalled that, within the framework of social cooperation on which this strategy was based, one of the government’s commitments was to maintain a predictable exchange rate. The solution to this apparent contradiction was the adoption of a much narrower band than the official one. The maintenance of the exchange rate within this tighter virtual band would mean a semi-fixed rate in practical terms. Chart 1 shows the virtual band with the daily evolution of the exchange rate.

From the adoption of the band regime to the summer of 1993 there had been a surplus supply of dollars in Mexico, and absolutely no one imagined at that time that the panorama would change, and still less so abruptly. This is why it was so surprising that, when NAFTA was ratified by the U.S. Congress, there was a considerable and unexpected outflow of capital, in response to which there was no need to commit international reserves. In his memoirs, Salinas de Gortari described the measures that were planned if the free trade agreement was rejected by the U.S. Congress. In that event, a considerable flight of capital was expected, a dangerous development to which the government would have to respond. Salinas has described the two positions which were taken in the discussions in his cabinet on this subject. One recommended raising the ceiling of the band in order to allow more room for the exchange rate to accommodate itself to unexpected conditions of supply and demand. The other suggestion was to increase the percentage deviation of the crawling band, mainly in the aim of sending a message of tranquility and confidence in the markets.[12]

Capital inflows pose difficult dilemmas for the economic policy of a receiving country. It is important to point out that, in the Mexican case, these were problems which the central bank could not provide help in solving. Economic policy offered only two possible responses to the situation. One consisted of allowing the market mechanisms to function without interference. That is, if capital inflows continued strong, it would be necessary to let the exchange rate appreciate and interest rates fall until these movements discouraged more investment from entering the country. Obviously, by setting a ceiling to the exchange rate, the Mexican authorities had implicitly rejected this first course of action. A second option was to apply administrative controls to capital inflows and outflows. Perhaps countries in South America, more distant from the United States, could have considered applying regulatory controls to the entry and flight of capital, but Mexico, with its long tradition of free exchange and its 2,000-kilometer-long border with the United States could hardly do the same. The least sign of an attempt to apply some kind of control would have provoked a massive capital flight with all its consequences.

In the passage of his memoirs cited above, Salinas mentioned that an adjustment of the exchange rate had to be permitted in unfavorable circumstances. He did not explain, however, that there were other mechanisms available to the authorities to defend the exchange rate regime in effect. One of these was in fact implicit in the functioning of the market. This was interest rates, which could be raised when the exchange rate depreciated in order to levy a double sanction on capital that was pulled out of the country. Thus, even as investment funds were obliged to abandon their peso positions through a price reduction, they would have to pay more for foreign currency owing to the depreciation of the exchange rate. International reserves provided another important instrument with which to intervene. The official view was that this option could only be used when the exchange rate hit the floor or the ceiling of the crawling band. Later on, at the height of the crisis, the government came up with yet another defense: the placement of Tesobonos —dollar-denominated treasury bonds— to replace public debt securities denominated in pesos.

Through its many achievements, the Salinas government had built up a considerable stock of credibility and confidence for Mexico. This confidence existed in broad segments of the national population and among foreign analysts and investors. It was highly unlikely that this entire stock of confidence could be exhausted by the impact of a single unfavorable event, however bad it might be. In the last months of 1993 and all through 1994, however, the country underwent an uninterrupted series of damaging and traumatic events that ended up undermining this stock of confidence, like water seeping through the foundations. With each successive event, the government used up a part of the margin available to it to buffer the damage and defend the exchange rate, but its options eventually ran out and the denouement of the story was the collapse of the system and a severe devaluation.

The first blow to the government’s credibility came with the announcement of the governing party’s candidate in the next presidential election. A different and even more deserving aspirant to the magical call made a public display of his dissatisfaction. Such a thing had never happened before. There was a sort of unwritten rule in the Mexican political system that the finalists in the contest to succeed the president would maintain a prudent silence and discipline if they happened not to be chosen. This had been going on for sixty years, since the creation of the political party in 1929. But new generations had arrived in the circles of power, changing both the content and form of political practices. Another even more serious development was the outbreak of the uprising of Ejército Zapatista de Liberación Nacional (EZLN) in the state of Chiapas, in which war was declared on the Mexican armed forces. The leaders of the movement, well connected with sympathizers abroad, especially in Europe, succeeding in giving wide international projection to their cause. In other circles the uprising provoked not only surprise but considerable concern. In any case, these events did not affect either capital inflows or the surplus in the capital account during the first two months of 1994. This can be proven by two facts. First of all, the exchange rate continued to feel downward pressure and remained near the floor of the crawling band. More importantly, international reserves continued to increase, shooting up by the middle of February to a high point of US$29.2 billion, or 15.7% more than at the beginning of the year.[13]

Leaders of the Zapatista National Liberation Army, which rose up in arms in January of 1994.

Nevertheless, the chain of traumatic events continued. In a blow to the perceived safety of the country, two prominent businessmen were kidnapped and the crimes received ample coverage in the media. On the political front, the negotiations to deal with the conflict in Chiapas and the behavior of the government’s delegate entrusted with them contributed to exacerbating the prevailing nervousness. Aggravating this state of affairs was the public perception that relations between the current president and the governing party’s candidate in the upcoming election had deteriorated. Obviously, the factor which contributed most tension of all was the assassination of the candidate Luis Donaldo Colosio and the sequels of that crime. Later on, just before the election, the Secretary of the Interior resigned, causing still more uncertainty. Nevertheless, the election was carried out successfully and things began to improve when yet another important political figure was assassinated. Things began to break down in the wake of this event and confidence was further undermined by the declarations made by the government attorney assigned to the case. By the end of the year, several other unfavorable circumstances ended up exhausting the government’s options for defending the exchange rate regime. The coup de grâce was supplied by the armed movement in Chiapas, which intensified its belligerent activities around this time.

José Francisco Ruiz Massieu, General Secretary of the PRI, assassinated in Mexico City in September of 1994.

The first instrument used to defend the exchange rate regime was the crawling band within which the rate could fluctuate to some extent. The first shakeup occurred, as we have seen, when uncertainty over the ratification of NAFTA by the U.S. Congress caused a transitory flight of capital at the beginning of November 1993. Although the exchange rate did not hit the upper limit of the band during this episode, it did rise by 5.46%, from 3.11 pesos to the US dollar on October 20th to 3.28 pesos on November 9th.[14] As Chart 2 shows, the rate returned to the floor of the band when it was announced that the legislation had passed. It remained fixed at this level for several months, as currency was again in plentiful supply and Banco de México took advantage of the opportunity by accumulating significant amounts of reserves. But this favorable panorama was interrupted by the assassination of the presidential candidate Luis Donaldo Colosio on 23 March 1994.[15]

Luis Donaldo Colosio, presidential candidate assassinated in March of the ill-starred year of 1994.

In the wake of the crime, for a relatively brief period, the exchange rate jumped from a level of 3.10 pesos to the US dollar to 3.35 pesos, at the upper limit of the band, representing a nominal devaluation of 8%. Confidence was so shaken that market rates remained at this level for several weeks. In an attempt to head off a collapse, the central bank was obliged to commit large amounts of reserves and interest rates were raised significantly. Once the destabilizing shock of the assassination had been absorbed, however, things began gradually to calm down and the exchange rate appreciated for a time. Unfortunately, this was only transitory, as the assassination of José Francisco Ruiz Massieu, general secretary of the governing political party, dealt yet another blow to stability. Following this second assassination, rates moved up to the upper limit of the band and remained there for a prolonged period, with no further appreciation until the rate regime finally collapsed on 21 December 1994.

The second defense mechanism was the commitment of international reserves, which the authorities decided to do in response to four particularly destabilizing events, as shown in Chart 3.[16] The most traumatic event was of course the assassination of the presidential candidate Colosio. Within thirty days of this event, the central bank’s previous international reserves of US$28.3 billion had dropped by US$11.0 billion. The second intervention came following the resignation of Secretary of the Interior Jorge Carpizo McGregor, as a little more than US$2.5 billion in reserves was committed in a lapse of eighteen days from June 24th to July 12th. This loss of reserves was compensated by a contribution by the federal government from its privatization revenues. The central bank was obliged to commit reserves again, in the amount of US$3.5 billion this time, following the accusations made by Assistant Attorney General Mario Ruiz Massieu, which generated serious concern about the stability of the Mexican political system. A fourth intervention by the central bank came after the resumption of hostilities by the Zapatista National Liberation Army (Ejército Zapatista de la Liberación Nacional, or EZLN) in December of 1994, which was accompanied by the forecast of some investors that Mexico would be unable to finance its current account deficit in 1995.

The third defense mechanism, the readjustment of interest rates, deserves a detailed account. Between early April and mid-May interest rates in the United States had gone up considerably, putting upward pressure on domestic rates in Mexico as well. Indeed, the adjustments to the exchange rate and to interest rates succeeding in reestablishing stability in the currency market until the assassination of Colosio took place. According to Banco de México’s 1994 Annual Report, “the reaction of interest rates was not long in coming: between the second-last week of March and the end of April, the average interbank interest rate, [known as] the tiip, went from 10.93% to 21.12%.”[17] Generally speaking, from the assassination of the candidate to November 1994, interest rates remained much higher than they had been in the first two months of the year. To illustrate the point, the aforementioned tiip averaged 10.97% in January and February but shot up to an average of 75.81% between the assassination of Colosio and the month of November. Chart 4 clearly illustrates this phenomenon, on the basis of three representative indicators: the 28-day Cetes rate, the wholesale rate, and the rate of the morning money market then set by Banco de México.

Finally, the case of the Tesobonos must be examined. These were offered to investors in substitution for other domestic debt instruments, mainly Cetes. Denominated as they were in pesos, Cetes, like Ajustabonos and Bondes, entailed an exchange risk. Given this situation, and the deterioration of confidence caused by the series of traumatic events just described, the Mexican government began to worry that, when these debt instruments came due, investors would enter the market in search of foreign currency. A mass phenomenon of this kind would put additional pressure on the exchange rate and require the commitment of even more reserves. This possibility had to be avoided. Given its importance here, we will quote the passage from Banco de México’s Annual Report in full:

[S]tarting in April of 1994 the Secretariat of Finance and Banco de México made it possible to replace pesos-denominated government bonds (Cetes, Bondes, and Ajustabonos) with Tesobonos, whose dollar value is not affected by fluctuations in the exchange rate. The issue of Tesobonos was carried out in order to relax the pressures on the exchange market. Given the growing perception of greater exchange risks among investors, there was increased demand for Tesobonos to replace peso-denominated debt instruments… It is reasonable that the financial authorities have used the resources and instruments at their disposal in their attempt to get through a situation that can justifiably be considered transitory.[18]

The collapse of the exchange rate regime finally took place in December of 1994, after newly-elected President Ernesto Zedillo was sworn in. On the political front, the Zapatistas intensified their offensive and made some particularly intimidating declarations on December 19. This development, combined with greater volatility in the financial markets and fear that the current account deficit would not be able to be financed in 1995, provoked a large-scale speculative attack on the peso, which by the end of the day had reduced international reserves by US$10.5 billion. Two possible courses of action were discussed that night at the Exchange Commission: one was to shift to a floating exchange rate the very next day; the other, which was finally adopted, was to raise the ceiling of band by 15% in order to give the exchange rate some breathing room. This decision was not well received by the markets and the consequences were disastrous. In just a few days, the central bank lost almost US$4.0 billion in international reserves.

In an atmosphere of great uncertainty President Ernesto Zedillo was sworn in on 1 December 1994.

Restoration

By the time the first Secretary of Finance of the government of President Ernesto Zedillo resigned at the end of December 1994, the Mexican economy had fallen into a severe crisis. The capital flight that, over the course of the year, had been limited or taken place in reaction to specific traumatic events turned into a torrent. The forecast was grim, with three problems of notable urgency. The first was the balance of the Tesobonos, their amortization schedule (all of them came due in the course of 1995), and the fact that Mexico had suddenly been shut out of the capital markets. The second great problem was the destruction of the macroeconomic equilibrium that it had cost so much work to restore and the loss of which threatened to unleash a wave of inflationary pressures. Without access to foreign credit, in a highly inflationary context, a slowdown of economic activity could be expected, with strong negative impact on real wages. This perspective of instability with recession was menacing, but the difficulties did not stop there. The third problem was the deterioration of the situation of the banks, of many families, of businesses of all sizes, and of producers, who had been saddled with debts that seemed all but impossible to pay.

The amortization of the Tesobonos would not have been a problem if Mexico had retained access to capital markets. With such access, these instruments could have been refinanced through the placement of new bonds on the market. Of course, this would have been easier if the country’s international reserves had been larger, so that they could be used to redeem some of the debt, at least during the first few months, while confidence was being restored and a rescue package put together for Mexico. But the lack of reserves and especially the unavailability of credit created a liquidity problem that, if it were not resolved, could turn into a genuine solvency crisis for the Mexican government. Financial authorities in the United States realized immediately the immense harm a suspension of payments would cause. President Clinton and his Treasury Secretary Robert Rubin were convinced from the start that doing nothing was the worst possible course of action. The great challenge consisted of convincing Congress to authorize a credible and sufficient rescue package.

Mexican President Ernesto Zedillo meets his U.S. counterpart Bill Clinton, who assured Zedillo of his support on the preparation of a rescue package for Mexico.

In contrast with the debt crisis that Mexico underwent during the eighties, this time government bondholders could not be easily located to negotiate with them.

Rubin’s memoirs of his term as Secretary of the Treasury include a detailed and insightful account of the preparation of this financial package, the perspectives of its possible success or failure, and the dilemmas the U.S. government had to confront in the face of a grave and imminent “Mexico crisis.” The most interesting aspect of his account is doubtless the doomsday scenario predicted by Rubin in the event of the U.S. government failing to address the problem facing Mexico, which he believed would end up affecting millions of families in his own country. Exceptional economists and financial analysts, Rubin and his second in command at the Treasury Department, Lawrence Summers, understood the stakes immediately and presented a convincing explanation of the dangers to President Clinton.[19]

The craftsmen of the rescue package for Mexico: President Bill Clinton and Secretary of the Treasury Robert Rubin.

Mexico, for its part, had appealed to the International Monetary Fund in the last week of January with a request for a Contingent Credit Line for 12.07 billion SDRs (approximately US$17.8 billion) at a term of 18 months. The Executive Board quickly approved the request on February 1st, making way for the largest operation in the IMF’s history. The speed of approval was an acknowledgment of the magnitude of the emergency and also of the coherence of the adjustment program the Mexican government had committed itself to applying.[20] A little more than one long month passed between the agreement with the IMF and the U.S. government rescue package, during which time the uncertainty and lack of confidence intensified greatly. Fortunately, the entire financial aid package came to US$51.2 billion, of which the United States contributed US$20.0 billion, the Bank for International Settlements US$10.0 billion, the World Bank US$2.8 billion, and the Bank of Canada US$1.1 billion, in addition to the aforementioned IMF credit.

This rescue operation was not headed only by the IMF.

The rescue package helped to mitigate the uncertainty but did not eradicate it. Confidence was gradually restored as the funds became available and the government securities —especially the Tesobonos— were redeemed on time, with Mexico gradually regaining access to the voluntary credit market. Even with the rescue package, in October and November of 1995 Mexico underwent another panicked and painful capital flight. Of course, the main component of the restoration was the liquidation of the Tesobonos, which ended up being a complete success. At the same time, thanks to the concurrent effect of the stabilization policies, international reserves gradually recovered in the course of the year. But it bears repeating that the most noteworthy achievement was the liquidation of US$29 billion in Tesobonos, all of which came due in 1995, by the end of the year.[21]

A couple of arguments frequently made in criticisms generated by the crisis in Mexico were that a lack of information provided by the Mexican government contributed to the formation and outbreak of the crisis, and that local investors, moreover, tended to be favored by what little information was provided. At the time, both hypotheses were critically analyzed in an important publication coauthored by Francisco Gil Díaz (then Deputy Governor of Banco de México) and Agustín Carstens (then general director of the central bank’s Economic Research Department). Regardless of the questionable soundness of either argument, however, the fact is that the notion persisted, especially outside of Mexico, that the government had not been fully transparent in disclosing economic information and that this information, moreover, was not provided on time. It was then the Mexican authorities decided to take the matter in hand and verify the truth of the accusations itself.[22] The main point of contention in the conflict was the question of disclosure of the balance of international reserves. In Mexico there existed a tradition, already half a century old, that this balance was to be announced only three times a year. The first of these channels was Banco de México’s Annual Report; the second was the address by the Governor (formerly the general director) of the central bank to the Bankers’ Convention, usually held during the summer; and the third was the “state of the union” address by the President on September 1st. Why express surprise at a practice that was known urbi et orbi?

Alan Greenspan, the Chairman of the Federal Reserve, greets Mexican Secretary of Finance Francisco Gil Díaz.

The weekly disclosure of the balance of international reserves was made possible by the change to a floating exchange rate regime. Apart from the question of restoring confidence in the financial markets, in the floating exchange rate regime public knowledge of reserve movements did not generate the kind of pro-cyclical reactions to be expected with a fixed or predetermined exchange rate. In general, Banco de México made efforts throughout 1995 to improve the frequency, timeliness, and accessibility of data concerning the main indicators of its operations and its actions in the area of monetary policy. In line with these efforts, in March 1995 Banco de México announced its calendar of publications, which was revised and expanded in 1996.

This policy of fuller disclosure began in mid-March 1995 with the weekly publication of Banco de México’s balance sheet, which included the balance of international reserves. Shortly thereafter, around mid-1995, the amount of the monetary base and the consolidated balance of commercial banks’ current accounts with Banco de México were announced at the end of every day, along with other complementary data. Also, on the twentieth day of each month, information on monetary aggregates and financial activities began to be released regarding the previous month. The traditional economic indicators were also available on floppy disk and, starting in August, a large part of the database of Banco de México was accessible by Internet. Finally, Banco de México published three documents on monetary policy in the course of the algid year: a report on 1995 policy in January, an update on the current year’s activities in September, and the central bank’s program for 1996 in December.[23]

As we have seen, the delay in preparing the rescue package had a high cost in Mexico. One of the consequences was that the monetary policy program originally drawn by the International Monetary Fund had to be discarded. From another perspective, as the nature and depth of the crisis became better understood, the economic policy response evolved from the set of measures designed to rein in spending, in order to bring down the current account deficit, to a different strategy, which, although it took these goals into account, also generated sufficient credibility to restore the market confidence in Mexico’s ability to meet its external and domestic obligations.[24]

The intervention of the International Monetary Fund was also essential to Mexico in its efforts to face the financial crisis which unleashed the so-called Tequila Effect.

The economic policy program for 1995 called for a necessarily restrictive policy. But in the specific and difficult crisis scenario, monetary strategy had to fulfill another objective: it had to be credible enough to restore confidence. This credibility could only be achieved by clearly demonstrating that Mexican monetary policy would be aimed exclusively at stabilizing the nominal economic variable in a manner consistent with Banco de México’s autonomy. The existence of a floating exchange rate left a single objective to monetary policy and, as a result, monetary policy became the sole nominal anchor of the economy. A precondition for achieving this end was that monetary policy be conducted independently of the banking problem, which also required attention.

One starting point of the 1995 monetary program were the criticism that had been made to the effect that, during the 1994 crisis, the Mexican authorities had been unable to adjust monetary policy in a timely fashion. Another premise was that, once the floating exchange rate regime had been adopted, Banco de México would acquire complete control over the monetary base and so be able to implement a strategy of quantitative goals for monetary aggregates. Concretely, what was done at the beginning of the year was to set the intermediate goal of a maximum ceiling for the expansion of the fundamental monetary aggregate. Since the floating exchange rate was expected to be maintained, no accumulation of reserves was necessary. It was considered that through control of the monetary base and the management of primary credit an effective brake on inflation could soon be applied.

Unfortunately, it soon became clear that this “simple and intuitive” monetary program was insufficient to stabilize inflationary expectations, the exchange rate, and inflation itself. The program was not credible and therefore failed to rally the collaboration of economic agents. In theoretical terms, what happens in a crisis scenario is that money circulates at a variable velocity, making the relation between the monetary base and inflation levels unstable. In practice, it could be seen that the central bank’s control over the monetary base was very incomplete, owing to the leftover liquidity that tends to accumulate in the current accounts of commercial banks.

In these circumstances of great volatility and uncertainty, the authorities reacted quickly and decided to apply a new monetary program. Not by chance, it was the kind of reaction expected by market participants: “a strong statement by the authorities that would make credible their stated intentions about reducing inflation.” Thus the strong trend toward the depreciation of the exchange rate was halted by the concurrent effect of three actions: first, a determined intervention which raised overnight interest rates to 86% in March of 1995; second, the announcement of the rescue package, which ensured the liquidation of the Tesobonos; and finally, the adjustment program itself, one of the foundation of which was a strict monetary policy. The modification of monetary policy required going from a strategy based solely on a quantitative goal for a monetary aggregate to one of a mixed character, which incorporated rules and the possibility of discretional interventions by the central bank.

This reformed strategy included two basic rules. One of them was the application of limits to the growth of the monetary base. For this, an accurate forecast of the behavior of the monetary base in the course of the year was important. The other rule, which was necessary in order to give Banco de México the possibility of discretionary intervention, was the implementation of the so-called zero balance regime in the current accounts that commercial banks hold in the central bank. This was basically achieved by the dual decision of not offering yields on the positive balances of these accounts but of applying a penalty interest rate of twice the prevailing Cetes rate to overdrafts. Once this system was in place, Banco de México would be able to apply a restrictive policy, keeping liquidity down and generating an overdraft in the consolidated balance of these accounts. This restriction of monetary policy was colloquially known as “applying a short position.”

The historical importance of this second focus of monetary policy, applied between the spring and summer of 1995, is that it had the desired effect: it stopped the depreciation of the exchange rate, which even began to appreciate by mid-year, reaching 6 pesos to the US dollar from its minimum of 7.50 in the difficult month of February. On the strength of this improvement, a refinement of the monetary focus began to be prepared for 1996. This modification was based on three fundamental premises. The first was the inclusion not only of rules for the monetary base but also of quantitative commitments on the accumulation of reserves and the variation of domestic credit. The second premise was that the central bank would adjust the money supply daily in order to meet demands. The third premise involved the possibility of discretional action by the central bank in to calibrate its position on monetary policy. Clearly, this position would have to lean toward restriction for some time, until the definitive stabilization of the economy was achieved.[25]

We have seen that the second variant of monetary policy put into effect in the middle of 1995 succeeded in quelling the panic generated by the spiral of devaluation. Inflation began to drop in January of 1996, from a high of 52% annually registered at the end of 1995. Annual rates continued to decrease, to 23.7% in 1996 and 15.7% in 1997. Another noteworthy result was the assertive handling of the public finances, which raised the primary fiscal surplus from 2.2% of GDP in 1994 to 4.1% the following year. Another corrective adjustment, also noteworthy and surprising, took place in the current account of the balance of payments, whose deficit of 7% of GDP in 1994 dropped to 0.6% in 1995 before inching up to 1.8% in 1996. An important feature of this correction is that it was achieved fundamentally by a large increase in exports and not a shrinking of imports.

The authorities had to act with speed and imagination in confronting the banking crisis caused by the spiral of devaluation in early 1995. Although this spiral was an important factor in the deterioration of the situation of the banks, it was by no means the only cause. Another important factor was the fast growth of deposits after 1990, and particularly of external liabilities, which doubled between 1991 and 1994. Yet another indirect factor was the reestablishment of the public finances, which freed up resources which would previously have been required to finance the deficit. All these factors explain the rapid expansion of loans to the private sector during the period in question, and these loans were being granted in a context of liberalized financial intermediation with a serious lack of supervision. Naturally following on the expansion of credit was an increase in non-performing loans, which grew from 3.1% of the total banking system portfolio in 1990 to 7.3% in 1994.[26]

The devaluation had a strong and almost immediate impact on inflation, interest rates, and the level of economic activity, with drastic repercussions for banks. The authorities reacted quickly, setting the basic guidelines to be followed in confronting the problem. First of all there was a goal, rather than a guideline strictly speaking: to avoid a run on the banks. It was further decided that support should be extended to the banking institutions themselves and not to shareholders and that the cost of the bailout would be shared by the federal government and the banking system. In this way, the cost of the rescue was lowered and spread out over a longer time. Also, the programs to shore up the banks were to include incentives for them to extend additional credit to sectors especially in need of a boost. As for debtors, the idea was to help the largest number of families and companies in paying off their loans, while at the same time raising awareness of the importance of meeting one’s obligations. This involved offering preferential treatment to debtors who were really willing to regularize their situation with the banks. Finally, and of great importance to the central bank: the bank rescue programs should not expand primary credit.

The strategy to rescue the banking system consisted of four types of programs: immediate action programs, bank support programs, debtor support programs, and other actions. Immediate action included a dollar rediscount window opened by Banco de México for those banks that were unable to refinance their dollar positions as they were coming due. This was a novel strategy: it was the first time in the history of the central bank in Mexico that the institution acted as a lender of last resort in foreign currency. And the mechanism was successful: help was provided to 17 commercial banks and by April of 1995 some US$4.0 billion had been committed.[27]

The second immediate action was also aimed at the banks. Owing to the devaluation, the peso value of dollar loans had skyrocketed, with the result that the capitalization ratios of some of the banks had fallen below legal limits. The solution was for banks in this situation to issue subordinated debt to be acquired by the government through a state-owned entity entrusted with administering the insurance offered to bank deposits and cases of insolvent banks. In general, these programs of repurchasing assets were designed to help the banks maintain legal levels of capitalization. Another method was the acquisition by the government of non-performing loans on condition that fresh capital was injected by new shareholders. A similar measure was the replacement of non-performing loans by long-term government paper with attractive yields. Unfortunately, not all of the institutions managed to stay afloat, in spite of these efforts. The cases of institutional bankruptcies were handled by intervention into the banks between the end of 1994 and August 1997. Twelve institutions were involved, representing 19% of the sector’s total capital.

Four programs were implemented to help out debtors with payment problems. The first was aimed at restructuring loans through a system of real interest rates, in order to avoid the advanced amortizations produced by inflation. In September 1995 the government also introduced a mechanism whereby credit card debtors, small and medium-sized businesses, agricultural producers, and mortgage holders could receive one-off financial aid. This included an interest rate subsidy that extended from September 1995 to September 1996. In fact, by the end of 1996, contracts had been signed by 73% of eligible debtors. In May of 1996 yet another program to help mortgage holders was launched. Finally, there were programs aimed at specific segments of the economy, such as the agricultural and fishing sectors, as well as complementary aid extended to small and medium enterprises.

Endnotes

A Difficult Takeoff

[1] “Nacionalismo Modernizador: CSG,” El Financiero (2 December 1988), front page.

[2] Banco de México, Informe Anual 1989, p. 86.

[3] Ibid., p. 12.

[4] Carlos Salinas de Gortari, México: Un paso difícil a la modernidad (Barcelona: Plaza y Janés, 2000), p. 60.

[5] Ibid., pp. 415 and 416.

[6] Banco de México, Informe Anual 1990, pp. 18, 114, and 121-123.

[7] Banco de México, Informe Anual 1991, p. 203.

[8] Banco de México, Informe Anual 1992, pp. 15 and 16.

[9] Miguel Mancera Aguayo, “La experiencia mexicana sobre las entradas de capital,” El Mercado de Valores (March 1992), pp. 27-31.

[10] Ibid., p. 28.

[11] Ibid., p. 29.

[12] Salinas de Gortari, México: Un paso difícil, pp. 189 and 190.

[13] Banco de México, Informe Anual 1994, pp. 44, 154 and 155.

[14] Banco de México interbank selling rate data.

[15] Banco de México, Informe Anual 1994, p. 42.

[16] Ibid., pp. 47 and 48.

[17] Ibid., p. 47.

[18] Ibid., p. 56.

[19] Robert E. Rubin and Jacob Weisberg, In an Uncertain World (New York: Random House, 2004), p. 18.

[20] Banco de México, Informe Anual 1995, p. 137.

[21] Ibid., p. 4.

[22] Francisco Gil Díaz and Agustín Carstens, Some Hypotheses Related to the Mexican 1994-95 Crisis, Banco de México, Documento de Investigación No. 9601 (1996), pp. 22-25.

[23] Banco de México, Informe Anual 1995, pp. 255-257.

[24] Agustín G. Carstens and Alejandro H. Werner, “Mexico’s Monetary Policy Framework under a Floating Exchange Rate Regime,” Banco de México, Documento de Investigación No. 9905 (May 1999).

[25] Ibid., pp. 15-18.

[26] Pablo Graf, “Policy Responses to the Banking Crisis in Mexico,” BIS Policy Papers (1999), p. 166.

[27] Banco de México, Informe Anual 1995, p. 98.

Central Bank Autonomy in Mexico

A Historical Overview

The publication consists of 10 volumes:

1. The Central Banking System in the World
With Preface and Foreword

2. Mexican Central Bank Autonomy: Historical Background

3. Concurrent Visions

4. Echoes from Abroad

5. Institutional Autonomy

6. A Difficult Takeoff

7. Unprecedented Stability
With Sources Consulted

Table of Contents

- A Difficult Takeoff

- Fatal Attraction
- Foreign Exchange Collapse
- Restoration
- Endnotes