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Archive for May, 2014

Mexican Flag

The Run on the Bank of Mexico.

As the presidential election campaign got underway, the highly charismatic Mexican presidential candidate Luís Donaldo Colosio was assassinated. José Francisco Ruiz Massieu, the PRI Secretary General, was put in charge of the Colosio murder investigation.

Then Massieu was assassinated.

All this was topped off with some high-profile kidnappings of Mexican business magnates.

One might think that the political instability reflected in these violent acts was bad enough, but it got worse. The Colosio/Ruiz murder investigations resulted in criminal charges against Raúl Salinas, the brother of President Carlos Salinas. Could things get any worse?

Well, yes they could. And they did. After the assassination of Colosio, the PRI ran the unknown Ernesto Zedillo Ponce de Leon as its presidential candidate. Although Zedillo won the election, the Mexican electorate generally disliked him and foreign institutional investors had little confidence in him.

These shocks led some larger tesobono investors to sell their holdings rapidly to get the hell out of pesos. The flight from the peso adversely affected dollar liquidity in Mexico’s domestic capital markets because of the increased demand for dollars. Mexican banks withdrew dollars from the Banco de Mexico, Mexico’s central bank, resulting in the loss of a good chunk of its foreign exchange reserves. This might not have caused an insurmountable difficulty had the Banco de Mexico hiked interest rates. Doing so would have restored some of its dollar-denominated foreign exchange reserves and helped maintain the fixed dollar exchange rate by allowing Mexico’s monetary base to shrink as people bought back into pesos. But interest rate hikes lead to economic downturns, and this being an election year an interest rate hike was not in the cards.

Instead, the Banco de Mexico took the opposite course and bought Mexican treasury securities in the hope that this would keep interest rates from rising. This put more pesos into the Mexican monetary base, which sparked inflation fears and ultimately required an even larger interest rate hike later that year. Buying these government bonds also drained even more dollar reserves from the central bank.

The feared flight of money out of Mexico then became a self-fulfilling prophecy: Individual investors, who were new to foreign capital markets, saw the withdrawals by the big boys and the decrease in foreign exchange reserves as a sign that, contrary to what they’d been told, Mexico was now a bad place to invest. (News flash: Wall St. Changes Its Mind.) Everyone started to run for the exits. That rational investor of whom economists are so enamored is still a human being who casts his rationality aside when, succumbing to a natural instinct for preservation of principal,  he magnifies each risk of loss far beyond its true proportion. Mexico in 1994 was no exception to this rule. Investors panicked even though Mexico’s economic fundamentals were nearly the same as they’d been the year before when investing south of the border was viewed as Wall Street’s good idea of the month. The election year largess had left the Mexican federal budget unbalanced, but the country was far from insolvent. A successful privatization campaign was underway. And the new man, Zedillo, though hardly charismatic, was viewed as a candidate who would continue the PRI policy of financial liberalization.

But it was too late. The run on the bank had already begun, albeit at the governmental level. This run was no different than that depicted in the 1946 movie It’s a Wonderful Life, except in 1994 Mexico found itself in George Bailey’s shoes. The problem Mexico and George Bailey had in common was one of liquidity, not solvency. Instead of having to turn to nasty Mr. Potter (Lionel Barrymore), Mexico turned to Robert Rubin and Bill Clinton who, after overcoming significant Republican opposition, engineered a bailout that kept Mexico from sliding into a South of the Border version of the Great Depression.

Mexico breathed a sigh of relief, albeit a shallow one. The Banco de Mexico had to implement the very measures it had earlier eschewed, namely, a hefty increase in interest rates and a devaluation of the peso. Mexican businesses took the full force of this blow. Thousands of Mexican businesses relied on supplies bought from the USA, and those bills still had to be paid in dollars. Many large Mexican businesses had taken out loans that had to be repaid in dollars. There were mass industrial layoffs, and several suicides that were well publicized in the business press of Mexico, though hardly noticed north of the Rio Grande.

Far more significant, though indirect, was the impact of this crisis on bank lending in the United States. While Mexico’s peso crisis certainly did not precipitate any corresponding dollar crisis in the United States, every American banker recognized what had just happened in Mexico and shared a common thought: There, but for the grace of God and the Bank Insurance Fund, go I. Still, their own borrowers did business in Mexico, and now the collection of those Mexican accounts receivable was in doubt. Depending on which report one reads, anywhere from 500,000 to 700,000 American jobs depended directly on trade with Mexico. The number of American jobs that depended indirectly on Mexico was much larger. The Rubin/Clinton bailout saved the vast majority of those jobs, but it couldn’t save all of them. American bank lenders also pulled in their horns, and in consequence 1994 was one of the weakest years in commercial lending since the Great Depression.

 

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Mexican Flag

This year will mark the twentieth anniversary of the Mexican Peso Crisis, an event that was mostly eclipsed by the 2001 internet bust and then completely eclipsed by the Financial Crisis of 2008-09. But the Peso Crisis was a harbinger of these later events. To borrow a title from Gabriel Garcia Marquez, it was a chronicle of a debt foretold.

The banking arena provides no finer examples of cause and effect than the events of the year 1994. In much the same way as one of Earth’s tectonic plates presses with increasing force on its neighbor, pressure in financial markets had been building up during the preceding years. And, much like the ground beneath us, this nearly unimaginable pressure remains undetected on the surface. When movement finally occurs, it’s cataclysmic. 1994 was such a movement.

For banks, 1994 was a caesura, a pause, between two eras. Behind them lay the 1980s, the age of the Wild-Haired LBO. In their future lay the promise of computer and internet technologies that pundits claimed would revolutionize commerce. The dot-com and telecom boom years, signs of which were then only dimly visible, had not yet dawned. People sensed that something exciting would happen at the racetrack on Saturday, but they hadn’t quite picked the horse on which to place their two bucks.

The first four years of the ‘90s were like a cold gray dawn that follows a drunken financial orgy, illuminating a sea of spent and naked transactional fannies sprawled across the floor. Bankruptcies, liquidations, workouts, and debt restructurings followed in the wake of the LBOs, all like so many emetics administered to the stumbling partygoers on their way out the door. 1994 was the little breather that followed these ministrations. And it was in this pause between two financial eras that Mexico gave us the peso crisis, the effect of which on banks, both real and psychological, should not be underestimated.

Beginning about 1990, when the LBO wave was ebbing and spare cash was looking for a high-return home, investors and lenders, including banks, got the wonderful idea that immense profits could be made in emerging markets. The term “emerging markets” is itself a euphemism. It practical terms it means a Third World country whose financial and legal systems were perceived as reasonably stable, and whose government had signed an extradition treaty with the United States. Since the fall of the Berlin Wall many of these nations had adopted macro-economic reforms that replaced their command-and-control economies with capitalistic free markets. Money from Wall Street seeking portfolio diversification, like Parsifal ever on the quest for the Holy Grail, began to flow into these emerging markets, slowly at first, and then rapidly. And from 1990 to 1994, the bulk of debt investment in emerging markets from the U.S. and Europe went into the emerging market that was at once the closest and the best: Mexico. [Cue mariachi music.]

At the beginning of 1994 the Mexican government was generally viewed as doing most things right. From about 1989 to 1994, the Mexican government budget had gone from a substantial deficit to a small surplus. Formerly state-owned businesses were privatized. Import restrictions had been lifted. And, most significantly, the Clinton administration had successfully secured Senate ratification of the North American Free Trade Agreement. With NAFTA, Mexican tariffs against the U.S. and Canada fell like Salome’s veils and the consummation (of deals, at least) began. Investment in Mexico boomed, and investors in both the U.S. and Europe looked forward to a continuation of market-oriented policies that would not only boost Mexican demand for American and European manufactured goods, but also make Mexico a highly attractive export platform to the rest of the world.

The Mexican boom gave rise to another trend. The capital that flowed into Mexico from institutional investors was soon followed by capital from small-scale individual investors, the overwhelming majority of whom were from the United States. One feature of this development received very little notice: This was the first time that individual American investors began to play a significant role in Mexican capital markets. And for nearly all of these individual investors these holdings represented not just their first time investing in Mexico, but their first investment in any foreign market.

But Mexico was not quite as happy as the picture painted for public exhibition by Wall Street and the State Department.

In January 1994, the Zapatista Army of National Liberation (EZLN) led an uprising in Chiapas, the southernmost and poorest of Mexico’s states. The EZLN insurgents protested the government’s lack of concern about poverty and the rights of indigenous ethnic groups. Though the EZLN and the Mexican government clashed militarily, they reached a ceasefire after about two weeks. Happy days were there again.

But for the EZLN, 1994 was a good time to schedule an insurgency. It was the last year of the sexenio, or 6-year term, of then-Mexican President Carlos Salinas de Gortari.

President Salinas, following the Institutional Revolutionary Party (“PRI”) campaign tradition for every election year, launched a massive government spending spree. This caused an equally massive federal budget deficit (about 7% of Mexico’s GDP) for that year. To finance this huge deficit and reassure the New York financial markets, the Salinas administration issued a new and unusual kind of tesobono, or Mexican treasury bond, which called for payment in dollars rather than pesos. This debt instrument was more attractive than ordinary Mexican government bonds because it eliminated exchange rate risk, which is one of the chief causes of allergic reactions among investors in emerging markets. If the foreign government devalues its currency, the investor won’t recoup its funds. Of course, to pay off these dollar-tesobonos, Mexico had to have sufficient foreign exchange reserves, namely U.S. dollar reserves. That’s where the problem started.

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