The missed opportunity: 1994-95 Mexico’s Economic Crisis

Evaluate policies of the past is one of the daily economist’s activities. Now is time to rethink about what happened fifteen years ago during 1995-94 economic crisis in Mexico, and go further, what could had happened without that crisis?

Central Bank’s version of the causes of 1994-95 Recession:

The exchange rate regime, bands flotation, was adequate to promote low inflation, fostering economic growth given the changes in the economic structure, and gradually decrease of current account deficit. However, the strategy was abandoned by two shocks: a rise in interest rates in international markets and domestic political events that pull out foreign investment. Otherwise the current account deficit could be adjusted gradually without a sudden and sharp exchange rate adjustment (Summarized from 1994 annual report of Bank of Mexico).

But there were failures, mainly the explained implicitly in Bank of Mexico’s report, as follow:

"As a result (after the cited shocks that dried international reserves), in 19 December 1994 the Exchange Commission decided to abandon the exchange rate arrangements reported within the "El Pacto” Committee to move to a floating regime. The committee was a widespread opinion to the effect that before going to a flotation, it was desirable to try to stabilize the foreign exchange market by raising the roof of the banda of fluctuation. However, when this measure didn’t succeed, it was agreed to move to a floating regime with effect from December 22 [...], the Mexican makers suffered a depreciation of about 71 percent in 1994” (Bank of Mexico, Annual Report, 1994).

A problem of imperfect information without clear plan to try to avoid the main problem: the lack of financial resources in dollars. Causing a massive speculative attack against the Peso, resulting in the follow macroeconomic environment in 1995 relate to 1994:

Variable	1994	1995
GDP, annual variation	4.4	-6.2
Inflation, annual variation	6.9	34.9
Current account deficit, as percent of GDP	-6.4	-0.5
Exchange dollar rate, percent of appreciation	26.5	94.9
Exportations, annual percent variation	19.1	23.9

During the worst of the recession, exportations compensated the plummet of other economic activities, mainly those activities exposed to internal demand. The exportations led the recuperation during 1996-2000. Otherwise, in absent of any devaluation, maybe the sector could had been equally successful, the external demand was vigorous, even during the peak of peso’s value in 1994 when exports growth 19.1 percent, without pull out resources from other sectors. 1994 was a well-balanced year across off all economic activities, each activity grew: manufacture activity, 3.6 percent; construction, 6.4; energy, 7.7; commerce, 2.8; financial services, 5.2; communications and transport, 7.8 percent. 1993 mild recession was also well-balanced with low cyclical-price pressures.

However, after the crisis in 1996, that year was a recovery unbalanced year, the recovery came from exportations of manufacture goods that put the economy out of the recession. The bi-annual variation of GDP by economic activity in 1996 in relation to 1994 was as follow: manufacture activity grew 5.4 percent; energy, 6.9; transport and telecommunications, 2.7 percent; Construction fall, -15.9 percent; commerce, -11.5 percent; and financial service with a sluggish growth of 0.2 percent. An awful economic growth, even when the economy in general grew 5.1 percent in annualized terms that year; awful because its implications on the welfare of Mexicana population and continued some years later, in the period 1996-2000.

This unbalanced growth during 1996-2000 had deep implications in distribution income and asymmetric regional development.

• High inflation, as always does, affected the distribution of income across segments of population; mainly workers, given that wages typically have a lagged behavior behind prices, so real wages under high inflation always fall; during this period the average rate of prices growth was 17 percent, while wages grew 15 percent; behind prices and gains in productivity.

• Asymmetric development in incomes. During 1995-2000, the GDP in north border estates grew 42 percent, on the other hand no-border states grew 27 percent and three south border states, Chiapas, Campeche and Tabasco, grew 16 percent in five years. Those states more relate to internal markets (retail sales, home and infrastructure construction, and services –as education and health) with sectors highly depend on financial markets as retail, they kept a potential growth below north estates, creating high regional disparities; surely, there were more variables behind, but the recession was a key variable.

Certainly the exports helped the economy grew outstanding, however the vigorous growth in exportations was not entirely linked to peso’s depreciation; the most important factor was the NAFTA, the fiscal regime to exporters, and external demand. However, what the recession really did was what we know: Ruined the financial system cutting the opportunity of a well-balanced growth throughout economic sectors, regions and population. On the other hand, maybe the recession could also be responsible of other government positive initiatives as fiscal reform, financial system reform, and private pension reforms; but the causality is not clear.

In short, Salina’s administration played a key role in the evolution of the recession because its bet for exchange rate regime that didn´t work and that expose heavily to the financial system and the entire economy to a system risk: a exchange rate regime very vulnerable to any shocks. Another key variable was the soft financial regulations that begun in a irregular privatization process of bank entities; and the lack of a deep public debt market (it could be helpful had had a private pension system, for example, to deepen the financial market). However, Zedillo’s administration didn’t make a plan to face the real problem there; high current account deficit, risky profile of public debt, and international tight credit conditions.

The way how the economy would had responded without recession can be answered by further empirical research. As always this could be a possible exercise; there are many hypothesis to solve and stylized facts to describe, for example some exercises to do:

• Proof that NAFTA and gains in productivity were the main variables behind the exporter boom in Mexico, to support the argument that the economy would had done better even in the absent of any kind of depreciation; under an adequate transition between exchange rate regimes.

• Make a stress test ex post to financial intermediaries in Mexico to know if they could had managed better themselves under a satisfactory transition of exchange rate policy (with lower inflation and country risk premium in interest rates), and so if we would had seen better figures on internal credit.

• Make simulations on how could be respond the income distribution without high rates of inflation and with better balanced economic growth across economic sectors.

• Testing the degree of sensitivity of economic growth by regions to variables as financial development, domestic and international demand. This factor would had been important behind the regional divergence in wages, income, and development, through the period 1996-2002.

These exercises could be valuable because it must help us to clarify some economic events of the past, mainly recessive periods, and take into account what are the lessons we learned.