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A Strong Peso Is Just What Mexico Doesn't Need

Economic Viewpoint


The Mexican economic debacle is nearing its first-year anniversary. Political turmoil in an election year combined with an overvalued peso translated into one of the more spectacular currency crashes in monetary history. Ineptness of borrowers and lenders alike sent the peso crashing, and it has not really stopped crashing even now. The value of the currency has more than halved, now hovering at approximately 7.5 pesos to the dollar compared with about 3 pesos last year before the crisis. Gross domestic product is down more than 6%, and politics is more charged than ever.

Despite the gloom in the markets, Mexico is poised to harvest the benefit of a decade of economic reforms. Even at its worst, Mexico will do O.K., with a 3% growth rate by the end of 1996. The big surprise is that it might do much better. The falling peso, which is worrying investors right now, may generate even higher economic growth.

In the 1960s and '70s, when Mexico did grow rapidly, the government was always the driving force. The public sector had plenty of money from oil. When the money was not there, the government could always borrow in world capital markets. But growth derived from private enterprise--financed through domestic saving and investment--was missing. Exports, except for oil, never played a role.

TWO WORLDS. This is about to reverse itself. The economic engine for growth has shifted dramatically to the private sector. But before it can reap the benefits, Mexico must deal with three immediate problems. First is the political crisis. The Institutional Revolutionary Party (PRI) is on the way out. It no longer has the power and money to narrow the gap between the poor south, where guerrilla warfare is rampant, and the rich north, which is modern, productive, and looks to the U.S. as an economic model. Bankrupt Mexico City can no longer bridge the two worlds. President Ernesto Zedillo Ponce de Len has five more years in his mandate. It is all but certain that the PRI will not nominate the next President as it has in the past, and the eventual transition to a new regime is unlikely to be smooth. The resulting political instability will probably translate into wariness about investment that is a brake to growth.

The second issue is the appalling state of balance sheets for Mexican banks and businesses. Squeezed by high interest rates that are being used to buttress the weak peso--20% real rates on T-bills and much higher on bank loans--companies, banks, and households are all teetering on the verge of bankruptcy. Moreover, banks with bad loans on their books must pay more for funds, which forces them to charge even more for good loans. That generates a vicious cycle and turns even more loans sour because debtors cannot service their escalating debts.

The third problem facing Mexico is the uncompetitive exchange rate. True, the peso has come down sharply, improving the country's trade balance. Mexico has also begun to pay off its U.S. mega-loan on time. But this is not sufficient. If the Mexican economy is to grow rapidly again, interest must come down dramatically to kick-start the private sector. And the peso should fall even further to spur exports.

PERENNIAL EXCUSE. Right now, government policy is to keep Wall Street and foreign investors happy. That means a strong peso and tight money at the expense of high economic growth. It is exactly the wrong policy prescription. The government excuse is that tight monetary policy is just for the short run, until markets normalize. But when will that be?

The other perennial excuse is inflation. Mexico's obsession with inflation was behind the overvaluation leading to the peso crisis of 1994, and it is at work again today. But there is a tradeoff. Chile, for example, grew in the past decade at about 6% per year. Inflation over that period averaged more than 15%, with far higher rates at the outset. Chile is not alone in accepting some inflation as a tradeoff for strong growth. Inflation is bad, but no growth is much worse.

Mexico can do better. The hard-money advice has served the country poorly. The right strategy today would be to get interest rates down and the private economy moving. Exports must be promoted, and the key lies in a competitive peso. Investors won't like this strategy, but that doesn't really matter. They also don't like bad politics and, on the current course, would bail out anyway. Fire sale devaluation works: The trade deficit has already disappeared. Although the government may be frantic, the fact is the falling peso contains the seeds of prosperity. Yes, there will be inflation--but without growth, Mexico's important shift from statism to a market economy will never yield dividends.BY RUDI DORNBUSCH

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