If the mexican government wants to keep the peso overvalued against the dollar, it will need to:

Economic Report

September 19, 2013, by Other authors

In August 1982, Mexico was the first of many Latin American countries to default on its sovereign debt. This Special Report first covers the main characteristics of the Mexican debt crisis. Second, the main causes and triggers of the crisis are described. Finally, details of the debt restructuring and reforms are discussed. 

The eruption of the debt crisis

February, 1982
A sharp decline in international reserves forces the Mexican government to devaluate the peso, increasing the dollar-denominated debt burden, mainly to US commercial banks (Figures 1 and 2). Despite the devaluation of the peso, Mexico is unable to stop its loss of reserves and runs out of cash. International reserves are only sufficient to cover three weeks’ of imports. 

August 12th, 1982
Mexico’s Minister of Finance Silva Hertog informs the US government and the IMF that Mexico is unable to service its external debt of USD 80bn (FDIC, 1997).

September 1st, 1982
The government nationalizes Mexico’s private banking system in order to prevent bankruptcy of the private banking sector and imposes comprehensive exchange controls. In the following months, a de facto moratorium on debt service exists. All payments on the private sector debt cease, as well as most payments on the principal of the public sector debt (Buffie, 1989). 

Aftermath

In August 1982, western central banks, at the behest of the US government and Federal Reserve Chairman Paul Volcker, arrange an unprecedented USD 1.5bn loan to Mexico, additional to USD 2bn in cash (oil prepayments and agricultural credits) from the US government. In essence, Mexico receives USD 3.5bn to relieve immediate cash needs, but only a 90-day rollover of the principal (Goldman, 1982).

In December 1982, the IMF approves a USD 3.8bn loan to the Mexican government. As a condition, the government has to implement a series of free market reforms. The IMF program ended in December 1985. Two more programs lasted from 1986 to 1988 and from 1989 to 1993.  The programs together amounted to 5.2% of GDP (Barkbu, 2011). 

Between August and December 1982, the peso is devaluated nearly 50% again the US dollar. Consequently, elevated inflation rates reach 100% and the economy turns into a recession. In 1982, the economy shrinks by 0.6%, followed by a shrink of 4.2% in 1983. Real GDP per capita falls with respectively 3% and 6% in 1982 and 1983. During the following five years, it decreases by 11% in total. In the same period, real wages fall by approximately 30% (Buffie 1989). Unemployment increases to high levels, especially in rural areas. In 1982, contractions in investment and consumption negatively contributed to economic growth (see figure 3).

Figure 3: Decomposition of economic growth

Source: OECD

After the devaluation of the peso in February 1982, net exports sharply increase, the only positive contributor to growth. In the five years after the crisis, Mexico’s terms of trade declined by 42.2%. But at the end of 1986, Mexico is still saddled with a huge foreign debt amounting to 78% of GDP and inflation exceeds 100%. In the same year, world market oil prices collapsed, adversely impacting the economy’s economic performance. Between 1983 and 1988, Mexico’s real GDP grew at an average rate of just 0.1% per year. Therefore, the 80s are considered to be the “lost decade”.

Short economic history

From the mid-1950s to the beginning of the 1970s, Mexico enjoyed a period of macroeconomic stability and economic growth. The inflation rate never exceeded, while annual economic growth averaged 7%. From 1954 to 1976, Mexico had a fixed exchange rate regime. The peso was fixed to the US dollar at 12.5 peso per dollar (see Figure 1).

In 1970, Mexico’s economic policy changed radically when Luis Echeverria was inaugurated as president. An enormous fiscal expansion took place and public debt started to increase. Consequently, budget deficits soared to 10% of GDP in 1975 and 1976. The growth rate of the monetary base accelerated to 33.8% in 1975. Consequently, inflation rose above 20% in 1973 and 1974. Meanwhile, the balance of payments deteriorated. Due to rising inflation, the real exchange rate appreciated rapidly and was largely overvalued. The current account deficit recorded 5% of GDP in 1975. Total foreign debt increased sharply to 31% of GDP in 1976. Almost all of this debt was held by the public sector, lent by international commercial banks (Buffie, 1989). Approximately three-quarters of the interest payments were tied to US interest rates and the London Interbank Offering Rate (LIBOR), which repriced every six months. Therefore, these credits were especially vulnerable to repricing risk driven by changes in the macroeconomic conditions of the creditor nations.

On 31 august 1976, under huge balance of payments pressure, the peso devaluated nearly 50% and the economy turned into a recession. Shortly thereafter, Lopez Portillo was installed as president. He reached an agreement with the IMF on a stabilization program. In the first year, inflation, the current account deficit and the budget deficit started to fall.

1979 - 1982: The run up to the crisis

Following the start of the production of newly discovered oil reserves in 1979, the IMF program was dropped and a more expansionary fiscal policy was implemented. Between 1978 and 1981, real GDP growth varied between 8.0 and 9.1%. The inflation rate accelerated but did not exceed 30%.

Since 1979, several factors worsened the debt service burden. When the second oil shock occurred in 1979, oil prices skyrocketed. This was favorable for Mexico as oil exporter, as it increased oil revenues. However, the following worldwide recession was a major negative factor, lowering net exports. In the same year, worldwide interest rates reached record levels. The increase in US interest rates was caused by the Federal Reserve’s policy to curb the oil-based inflation of the 1970s. This resulted in rising US dollar exchange rates, increasing the difficulty of servicing debt. Compounding this, as about three-quarters of interest payments were tied to variable interest rates, debt service payments increased and made debt repayment more difficult.  In 1981, LIBOR peaked at 16.7% on average, before lowering to 13.6% in 1982.

Figure 4: Change in international reserves

Source: Banco de México

Another feature was the overvalued exchange rate of the peso. From mid-1978 to mid-1980, the nominal exchange rate was held constant, even though annual inflation exceeded 20%. The resulting overvalued exchange rate generated fears of devaluation, leading to more capital flight. Nevertheless, heavy borrowing continued (FDIC, 1997). From mid-1980 to early1982, the peso gradually depreciated 16%, while annual inflation recorded nearly 30%. As a result, the real exchange rate appreciated steadily. The real interest rate turned negative, further stimulating debt accumulation. In early 1982 the peso was left to float freely until June 1982. Consequently, the peso depreciated around 50%. However, this was not enough to end overvaluation. Nevertheless, it was a sudden worsening of the terms of trade, decreasing by 13% in 1982. Increased financial instability and prospects of further devaluations stimulated further capital flight. The weak government response around the elections in 1982 raised uncertainty and aggravated the situation. In 1981 and 1982 capital flight was estimated at respectively 3.4% and 4.2% of GDP.

In 1980, government expenditures escalated, resulting in large fiscal deficits, since it was not matched by a similar rise in revenues. Non-oil revenues even decreased, principally due to the government’s reluctance to raise administered prices (Buffie, 1989). The budget deficit grew steadily to 14.7% in 1981. Public debt recorded 42% of GDP that year, while external debt had already increased to 33% of GDP. After the devaluations of the peso and rising global interest rates, Mexico’s external debt reached 49% of GDP in 1982 (see Figure 1). Debt service absorbed 142% of total current account income and 24% of GDP (Buffie, 1989). As a result, in August 1982, Mexico was no longer able to service its external debt.

Debt restructuring

In 1982, the government began with a two-year respite from large scale debt service payments, granted by US commercial banks. On 10 December 1982, an agreement was reached with the commercial banks to reschedule USD 23bn of capital payments on the public sector debt coming due between 23 August 1982 and 31 December 1984. During the same period a wide-ranging stabilization program was agreed with the IMF. The program also included structural reforms.
At the time of the Mexican default, debt often exceeded the capital base of many of international banks. Therefore, many feared that the banking system would collapse.

In the face of falling economic growth rates and rising inflation, the “Baker plan” was implemented in 1982, proposed by US Treasury secretary Baker (van Wijnbergen, 1991). In return for economic reforms, high-debt countries would get new access to medium-term new loans, in addition to rolling over of amortization of old loans. New loans had to come both from commercial creditors and the official lending institutions. In June 1983, the “Paris Club”, representing creditor governments, rescheduled Mexico’s sovereign debt owed to major creditor countries (World Bank, 2004). The Paris Club is an informal group of financial officials from most western economies, which provides financial services such as debt restructuring and debt relief. With access to capital markets restored, it was hoped that the economic reforms would allow the debtors to grow out of debt. However, capital outflows went up rather than down, inflation skyrocketed, investment fell and over the period 1982-1988, no economic growth took place in Mexico at all. Consequently, external debt rose to 78% of GDP in 1987, marking the failure of the “Baker Plan”.

In September 1989, the “Brady plan” was agreed, legitimizing the concept of debt relief. By now, it was believed that US banks could withstand projected losses on Latin American debt (Tammen, 1990). The “Brady Plan” forced them to do so. The basic idea was to make debt relief acceptable to commercial bank creditors by offering a smaller but much safer payment stream in exchange for the original claim that clearly could not be serviced in full (FDIC). The Mexican government and the Bank Advisory Committee representing the commercial bank creditors reached an agreement on a financing package covering the period 1989-92, restructuring approximately USD 49.8bn of Mexico's external debt. As only long-term debt with commercial banks was restructured, roughly half of the debt was involved (van Wijnbergen, 1991). Commercial banks involved had three options (Odubekun, 2005):      

1. Banks could exchange old loans for new bonds at a discount of 35% of their face value, keeping interest rates at market levels (equivalent to LIBOR +  %)
2. Banks could exchange old debt for face-value new bonds (called par bonds) bearing fixed interest rates of 6.25%
3. Banks could provide additional loans over the next three years equivalent to 25% of the banks’ initial medium- and long-term loans, which implied no debt relief but the provision of new money

Most banks opted for the par bond (47%), implying interest rate reduction. Other banks chose to reduce the principal (40%), a few offered new loans (13%). Another agreement was reached with the Paris Club, representing creditor governments, covering USD 2.6bn of principal and interest payments falling due in the period 1989-1992 (van Wijnbergen, 1991).

The “Brady plan” substantially improved Mexico’s ability to service its external debt by reducing interest and principal payments (Dornbusch, 1994).

Structural reforms

In December 1982, Mexico started far-reaching structural reforms, which were a condition for receiving the IMF loan. The reforms included: fiscal austerity, privatization of state-owned companies, reductions in trade barriers, industrial deregulation, and foreign investment liberalization. Owing to rigidly enforced fiscal discipline, the budget deficit halved from 17.6% in 1982 to 8.9% in 1983. Fiscal austerity was accompanied by stringent monetary policy.

With an extensive trade reform, Mexico opened up the economy. The percentage of domestic (non-oil) tradable production covered by import quotas was lowered from 100% in 1984 to less than 20% in 1991. Also, maximum import tariffs were cut. As a result, non-oil merchandise exports doubled their share of total exports to two-thirds. In May 1989, foreign investment regulations were considerably relaxed and made more transparent.

Also the tax system underwent a number of reforms, encouraging capital inflows and raising sanctions for tax evasion. The government also initiated a process of financial market liberalization. Ceilings on commercial banks’ deposit interest rates were removed. Forced allocation of commercial credit towards favored sectors had also been abolished and credit subsidies through official development banks had been reduced. In 1991, Mexico started to privatize the commercial banks, which were nationalized in 1982. However, banking sector reforms were delayed. Mexico still lacked inadequate banking sector supervision, although the government guaranteed both deposits and liabilities. See Special Report 2013/15: The Tequila crisis in 1994.

Conclusion

In August 1982, Mexico was not able to service its external debt obligations, marking the start of the debt crisis. After years of accumulating external debt, risen world interest rates, the worldwide recession and sudden devaluations of the peso caused external debt payments to rise sharply. Since November 1982, several forms of debt restructuring were applied, including the Baker plan and Brady plan. Under the Brady plan, US banks assumed the losses on Mexican debt. The IMF assisted with three financial packages, which were accompanied by structural reforms.

Author: Koen Brinke

References

Barkbu, B., Eichengreen, B. and Mody, A. (2011),  International financial crises and the multilateral response: what the historical record shows. NBER Working Paper 17361.

Buffie, E.F. (1989), Mexico 1985-86: From Stabilizing Development to the Debt Crisis. Developing Country Debt and Economic Performance, NBER.

Dornbush, R. and Werner, A. (1994), Mexico: Stabilization, Reform and No Growth.

FDIC (1997), The LDC Debt Crisis, An Examination of the Banking Crises of the 1980s and Early 1990s, Federal Deposit Insurance Corporation

Odubekun, F. (2005), Debt Restructuring and Rescheduling, US Treasury Department.

Pastor, M. (1989), Latin America, the Debt Crisis, and the International Monetary Fund, Latin American Perspectives, Vol. 16, No. 1.

Tammen, M.S. (1990), The Precarious Nature of Sovereign Lending: Implications for the Brady Plan, Cato Jounal, Vol. 10, No. 1.

Weintraub, R.E. (1984), International debt: Crisis and challange

Van Wijnbergen (1991), Mexico and the Brady Plan, Economic Policy, Vol. 6, No. 12. World Bank.

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