We Have Salinas To Thank For The Peso DebacleRudi Dornbusch
The crash of the Mexican peso is just one more example of the cycle of delirious optimism followed by collapse and bottomless gloom in Latin American finance. The peso's fate has ruined investors' end-of-year bonuses and is a major setback to Mexico's prospects. A postmortem is instructive. The blame lies squarely with former President Carlos Salinas de Gortari.
Mexico last crashed in 1982, following a borrowing spree in the late 1970s. Debts to commercial banks around the world went into default; the peso was devalued again and again in an attempt to gain a trade surplus to meet the demands of creditors. But even as the currency went down, inflation exploded. That vicious cycle of inflation and depreciation peaked in 1987 with inflation well above 150%. Pressured by events, reform and stabilization became the central objective. Much good was done: privatization, trade liberalization including the North American Free Trade Agreement, deregulation, and budget balancing including fiscal reform.
FOOL'S GOLD. External confidence recovered, investment money started to return, external deficits ballooned. With easy access to financing and much of the domestic agenda accomplished, reducing inflation to U.S. levels became the central preoccupation. Depreciation of the peso was unwisely kept far below the rate of inflation, a policy that helped slow inflation but also meant an increasingly uncompetitive trade position. At the outset, that could be rationalized by renewed access to world capital markets and the rewards of a reformed and stabilizing economy. But at some point, competitiveness had to be restored. By 1993, Mexican producer prices expressed in dollars had risen by more than 45% compared with prices in the U.S. Clearly the peso had become overvalued, but Mexican leaders refused to acknowledge the facts, and foreign investors were lulled into holding on to exposed positions.
Salinas and his policy team reasoned that real appreciation held no problems: NAFTA would bring direct investment and trade opportunities. Deficits were large now but would be small in the future. In any event, money was not thought to be a problem because international investors had developed a mad crush on Mexican stocks and treasury bills. Overvaluation became troublesome when the upcoming 1994 election brought with it the possibility of changes in economic strategy or a show of weakness by the official party. Indeed, politics turned nasty (the Chiapas uprising and two assassinations), causing some eyebrows to raise. But investors were assured daily that all was well: The peso would never be allowed to fall. The foreign loans kept coming, but at higher interest rates, which combined with lack of competitiveness to strangle growth. No growth plus a gigantic external deficit--some 6% of gross domestic product--made it certain the peso would yield sooner or later.
QUICK FEET. Yet Salinas persevered with his strategy of politics first, reality later, and the peso remained disastrously overvalued. The myth of a superperforming Mexican economy was kept alive. Criticism was not brooked, especially by Cabinet ministers who nursed an ambition to be the next holder of absolute power. Chilean dictator General Augusto Pinochet painted himself into a similar corner in the late 1970s. Just as Pinochet and his toadies ignored common sense in currency matters, Salinas believed that with enough manipulation and censorship he could keep the peso afloat. In the end, both turned out to be wrong in a strikingly similar manner.
Without Chiapas, the crisis might never have happened. But there is always some extraneous event that makes the glass run over. If the currency is badly out of line, it doesn't take much. But why the seemingly bottomless drop of the peso that is occurring now? Here, the analogous situation is a bank run. Mexico dissipated its reserves in an attempt to sustain various unrealistic levels of the peso. In such a predicament, no one wants to be the last one out--or the first back in: Investors fled en masse. Ultimately, they will return, but only when assets are dirt cheap. Just as in real estate, there is always another boom: It just doesn't come in time to help the holders of the hot potato.
Mexico's per-capita income today is still 5% less than it was in 1982, at the time of the last crisis. The easy money is gone, and real income will be falling further. The brilliant reforms implemented by Salinas were about to put his nation on the path of prosperity; his utterly misguided currency experiments instead plunged the country into economic and possibly political turmoil. Mexico will enter the next century far poorer than it was two decades ago.