The Mexican Financial Crisis in 1994 and the Asian Crisis 1997 - Causes and Effects

The Mexican Financial Crisis in 1994 and the Asian
Crisis 1997 - Causes and Effects

by: Sascha Kern

Table of Contents

Introduction  - 3 -

1 Macroeconomic Environment  - 4 -

1.1 Mexico  - 4 -
1.2 Asian Economies - 5 -

2 Outbreak of the Crisis - 6 -

2.1 Mexico 1994  - 6 -
2.2 Asian Economies - 8 -

3 Comparison  - 11 -

3.1 Warning signals?  - 11 -
3.2 Financial fragility - 13 -
3.3 Investors sentiments and open economies  - 14 -
3.4 Policy responds  - 14 -

4 Conclusion - 16 -

References - 17 -

"The market is a beast. When you open your economy to the international
financial markets, you should know that you are inviting a beast into your
house. Once he is in, he will do what he pleases."
- A New York market participant, March 1998

Introduction

The present work deals with the macroeconomic consequences of capital imports in open national economies. There are quite a lot of similarities when comparing the Mexican financial crisis in late 1994 and the Asian financial crisis between 1997 and 1998. In both cases the failure of monetary and fiscal policy and the fact that we are living in a world where capital is highly mobile were the main reasons which led to the crisis. By comparing the two crisis and their grounds we realize how helpless and vulnerable emerging countries are when it comes to sudden capital outflows.

Equally, the problems occurred in Mexico and the Asian economies surprised many experts. Institutions, like the International Monetary Fund, lauded and praised these economies as new models which should be followed by other countries. This paper is structured as follows: In Chapter 1, a brief overview is given on both economies, especially their macroeconomic environments before the crisis. To understand the main reasons of the crisis it is necessary to be familiar with the situation in both economies. Chapter 2 deals with the reason and circumstances that causes the outbreak in the end. Here I am focusing on each economy individually. In Chapter 3 both cases are compared, concentrating on four major aspects. Moreover I want to emphasize on the lessons for the future and how emerging market can avoid financial crisis by becoming less vulnerable against the power of international capital markets.

1 Macroeconomic Environment

1.1 Mexico

Till the end of the eighties Mexico faced a high amount of foreign debt. The access to the international capital markets was very limited. The living conditions within the country deteriorated and inflation rose to 200% at its peak. However in the mid eighties, Carlos Salinas¹ introduced quite a lot of reform programs. The new reforms were characterised by the consolidation of the fiscal budget, the privatization of many state owned companies and the liberalization of trade. The proceeds of privatizations were used to improve public finances through debt reductions. The average net debt of the public sector, as a proportion of Gross Domestic Product (GDP), fell from 74.4% in 1987 to 22.5% in 1994². Another main aspect was the launching of a fixed exchange rate to fight inflation. After a fixed exchange rate was introduced in 1988, a crawling peg was established in November 1991. As a support of the anti-inflation program the so-called Pacto was decided in 1987, which was a wide social alliance by the state, enterprises and trade unions. The contents of this agreement were wages and price controls and a restrictive monetary and fiscal policy to stabilize the price level. Further, it is important to mention the Brady plan in which the USA decided in 1990 to put aside debt claims against Mexico and several Latin American countries.

Accordingly as the reform took effect, Mexico became confident and experienced economic renaissance. Consumption rose in expectation of future higher income. The interest rates in the U.S. decreased because of recession and investors looked into the emerging market. A series of quotes suggest the flavour of that time:

“There is no other country in the world where I can buy government funds that yield so much and are safe.”³ “The time to be invested in Mexico is now.”⁴ Mexico, behind its crisis in the past, became the favourite of the international financial community. By 1990, capital flooded into the country and prospects seemed unbounded. The creation of the North American Free Trade Agreement in 1994 was supposed to maintain this success story. The success of the anti-inflation program until 1994 is illustrated in Graph

Graph 1, Dresdner Bank Latin America, www.dbla.com [graph only in downloadfile]

1.2 Asian Economies

[...]

1 Carlos Salinas de Gortari (born 3 April 1948) was President of Mexico from 1988 to 1994

2 Diaz and Carstens (1996)

3 Robert Beckwith, Fidelity Investments, 22 April 1993, New York Times

4 Maria-Elena Carrion, Bloomberg, 23 August 1994