The Origin of Mexico's 1994 Financial Crisis

Vol. 17 No. 3

THE ORIGIN OF MEXICO'S

1994 FINANCIAL CRISIS

Cato Journal, Winter 1998, v. 17, iss. 3, pp. 303-13.

Francisco Gil-Diaz

After nearly a decade of stagnant economic activity and high inflation in Mexico, the Mexican government liberalized the trade sector in 1985, adopted an economic stabilization plan at the end of 1987, and gradually introduced market-oriented institutions. Those reforms led to the resumption of economic growth, which averaged 3.1 percent per year between 1989 and 1994. In 1993 inflation was brought down to single-digit levels for the first time in more than two decades. As its economic reforms advanced, Mexico began to attract more foreign investment, a development helped by the absence of major restrictions on capital inflows, especially in the context of low U.S. interest rates. Indeed, large capital inflows began in 1990, when a successful foreign- debt renegotiation was formalized. The devaluation of the peso in December 1994 put an abrupt end to these capital inflows and precipitated the financial crisis.

Regulatory Failures, Credit Growth, and the Onset of the Crisis The financial sector also underwent a substantial liberalization, which, when combined with other factors, encouraged an increase in the supply of credit of such magnitude and speed that it overwhelmed weak supervisors, the scant capital of some banks, and even borrowers.[1]

Several factors contributed to facilitate the abundance of credit: (1) improved economic expectations; (2) a substantial reduction in the public debt;[2] (3) a phenomenal international availability of securitized debt (see Hale 1995);(4) a boom in real estate and in the stock market; and (5) a strong private-investment response.

Poor borrower screening, credit-volume excesses, and the slowdown of economic growth in 1993 turned the debt of many into an excessive burden.

Nonperforming loans started to increase rapidly. A process of adjustment of the balance-sheet position of the private sector, underway by the second half of 1993, and the late adoption by some commercial banks of prudent policies were signs that nonperforming loans had exceeded reasonable dimensions before 1994.[3]

The substantive causes of the debt increase were: [9]

1. The financial sector was liberalized: lending and borrowing rates were freed, the forced channeling of credit was abolished, and bank reserve requirements were eliminated.
2. Banks were hastily privatized, in some instances with no due respect to ``fit and proper'' criteria, either in the selection of new shareholders or top officers (see Honohan 1997: 13, and Ortiz 1997). It must be noted, however, that on average the banks remained in government hands for half of the expansionary period.
3. Several banks were purchased without their owners proceeding to their proper capitalization. Shareholders often leveraged their stock acquisitions, sometimes with loans provided by the very banks bought out or from other reciprocally collaborating institutions.
4. The expropriation of the commercial banks in 1982 contributed to their loss of a substantial amount of human capital during the years in which they were under the government. With these officials institutional memory migrated as well.
5. Moral hazard was increased by the unlimited backing of bank liabilities.
6. There were no capitalization rules based on market risk. This encouraged asset-liability mismatches that in turn led to a highly liquid liability structure.
7. Banking supervision capacity was weak to begin with, and it became overwhelmed by the great increase in the portfolios of banks. Part of this weakness originated in the political stature of government-appointed CEOs when banks were still government owned.
8. There was a substantial expansion of credit from the development banks.
9. From December 1990 on, foreigners were allowed to purchase “domestic'' (short-term) government debt. Since domestic public debt decreased during this period, the purchases of Cetes by foreigners enhanced the purchasing power of their domestic sellers.