Mexico - Peso Crysis

Mexico, being a major oil exporter during 1970s enjoyed an increase in export earrings due to increase in oil prices during that time. Optimistic about future increase in oil prices, Mexican government adopted fiscal policies & reforms to develop the infrastructure of the country. Due to the fall in international oil prices during early 1980s, the revenue that the Mexican government had anticipated from oil export was severely diminished. The reduction in revenues, coupled with rising interest rates throughout the world lead to large fiscal budget deficits. When a severe recession hit the Mexican economy during 1982, the country's government nationalized the banks and imposed huge tariff on imports to protect the domestic producers. This lead to a period of economic contraction during which the country's real per capita GDP was negative. When reform began during the end of 1980s, government reduced tariffs on imports to encourage trade and price stability, fixing the exchange rate of peso to dollar and adopted market oriented reforms such as privatization of resource and industry.

At the beginning of 1990s, Mexico enjoyed it first positive economic growth in decades due to trade liberalization. There was a huge inflow of funds, especially from abroad, to its capital markets which favorably affected its balance of payments. The Mexican government joined NAFTA in the early 1990s, while still maintaining fixed exchange rate of 3.5 pesos to the dollar in order to promote trade among the NAFTA member countries and to ensure smooth inflow of capital funds into its capital markets. This decision of the Mexican government of maintaining a fixed exchange rate made the economy vulnerable to instability. Although higher interest rate and fixed exchange rate encouraged huge inflow of capital funds from abroad but, these were a very liquid form of savings that can be moved from the economy almost overnight when conditions change. Moreover, by keeping the value of the peso high, and thus import prices relatively low, Mexico was sacrificing domestic production in favor of imports which unfavorably affected the balance of payment.

During 1994, Mexico suffered a large current account deficit due to increased demand for imports. Moreover, increase in interest rate in US, where most of the capital flow got into the country, have resulted in an abrupt reversal of the flow of financial money from Mexico to US. These things along with unstable political environment in the country had put a downward pressure on peso and as a result the value of peso was devaluating. In order to maintain the fixed exchange rate of peso against dollar, the Mexican government had to use its foreign currency reserve and by the end of the year, the government had almost depleted its foreign reserve which had shrunk from $29 billion to $6 billion.

In order to minimize the balance of payment problems, the Mexican government could have