Mexico: A Quarter Century of Unfulfilled Potential

Mexico’s recent economic history is littered with financial instability. The recurrent currency, debt, and banking crises of the past quarter century had a ruinous effect on real economic activity. Mexico’s election years frequently intensify the risk of financial devastation. Massive devaluations, debt defaults, or both have accompanied three of the last five presidential elections – and history could easily repeat itself if the disputed 2006 elections continue to spur unrest into 2007. While Mexico is clearly not immune to economic catastrophe, Mexico has taken many strides toward ameliorating the fiscal infirmities that allowed the 1994 Tequila Crisis.

Mexico’s modern economic history begins in 1976, a tumultuous year that witnessed a rescue loan package from the Federal Reserve and US Treasury in April, the election of President Jose Lopez Portillo in June, the first peso devaluation in 22 years in August, and the discovery of enormous oil reserves. High oil prices fueled tremendous government spending, and the resultant triple threat of a weakening trade balance, yawning government budget deficits, and rapidly rising inflation endangered Mexico’s fixed-exchange-rate system. Foreign investors countered in the early 1980s by reducing their positions in Mexico and converting a large fraction of their Mexican bank deposits to dollars. In the run-up to the 1982 presidential election, the monetary authorities did little to address the country’s deteriorating financial situation and quickly found themselves unable to defend the country’s currency. Mexico sharply devalued the peso in February 1982. In August, the country announced it could no longer meet its short-term, dollar-denominated obligations. December bore witness to another sharp devaluation.

The 1982 crisis triggered Mexico’s worst recession since the Great Depression and prompted drastic policy reforms. During the 1980s, the country took steps to raise tax revenues and limit fiscal spending. Restrictions on foreign investment and trade were lifted gradually. In 1986, Mexico joined the General Agreement on Tariffs and Trade (GATT). Between 1985 and 1990, the country’s maximum tariff fell from 100 percent to 20 percent. Most sectors opened to foreign investment in 1989, paving the way for a wave of privatizations. By 1994, 80 percent of state-owned firms had been sold off.

The country’s growing commitment to policy restraint and reform began to pay off in the late 1980s with lower interest rates, lower inflation and declining debt-to-GDP ratios. In 1989, after the Brady Plan marked the completion of the debt-renegotiation process, Mexico finally regained access to international financial markets. In fact, foreign direct investment started flowing into the country at unprecedented rates. Yet by the end of 1994, in another presidential election year, Mexico once again suffered financial crisis. Unrest in Chiapas, along with the assassinations of the leading presidential candidate and the ruling party’s leader, fed uncertainty and increased speculation against the peso. As the government began to rely increasingly on short-term, dollar-denominated debt, the ratio of short-term debt to reserves rose sharply. In December, Mexican authorities announced yet another vast devaluation of the peso.

Sustained financial instability has ensured Mexico’s inability to achieve consistent economic gains. In 1983, real GDP per capita fell by more than 6 percent. Between 1982 and 1994, Mexico experienced no overall growth. During the Tequila Crisis, GDP per capita fell by almost 10 percent. Even with the past decade’s relative stability, GDP per capita has grown by an average of less than 1 percent a year since 1980.