In 1994 the interest rate increases due to the recovery of Western economic. At that time, the political situation at Mexico was unstable so lots of foreigner investors withdraw from their investments. This lets Mexico lost lots of its foreign reserve holdings and it was running out when the new president Ernesto Zedillo took over the position. Thus, the government announced its decision to devalue the peso against the dollar by 14 percent to boost exporting. In other words, the Mexico government was trying to reduce goods imported and prevent capital outflow. The following figure shows that the account balance, net trade, and net income hit the lowest points in 1994.In addition, we can also look at exchange rate for Mexico and US from 1994 to 1995.
We can know that the exchange rate was decrease dramatically. People were restless buying large amount of US dollar due to of Mexico’s decision for devalue.The main reason that led to the difficulty of the balance-of-payments in Mexico is they use the inflow of foreign capital to solve the balance of payments deficit. Mexico’s new economic policy started in 1988, which did receive some effect.
However, due to the large differences in inflation between Mexico and the United States, the exchange rate of the peso to the U.S. dollar has not been adjusted for a long time, causing an overvalued currency. After participating in NAFTA, Mexico imported much more rapidly than before, causing the trade deficit to rise. To balance the current account deficit, Mexico borrowed heavily. due to the situation has fluctuated, the government must use its foreign exchange reserves to solve the decrease of foreign investment. The sudden drop in foreign exchange reserves undermined support for domestic currencies, and the government has to use currency devaluation to prevent foreign exchange losses and finally cause the peso devaluation.
In order to prevented or mitigated the balance-of-payments problem and the subsequent collapse of the peso, there are several policy actions can be applied. Firstly, Mexico should have more domestic saving which belongs to long-term investments rather than rely more on short-term foreign capital investments. Secondly, limiting the range of the frequency fluctuations in the nominal exchange rate. After Mexican crisis, they used floating exchange rate, however, this lead to the serious inflation, the unstable interest rates and the foreign exchange rate.
Mexico needs to develop the future exchange market, but this lead to the additional volatility problems, so Mexico needs to set the highest and the lowest frequency fluctuation for the nominal exchange rate. In addition, Mexico can improve the connection with the International Financial Markets especially the norms of transparency. Transparency always helps prevent financial crises. Besides, establishing a multinational safety net can help Mexico prevent the peso crisis.
1. A multinational safety net must be established to safeguard the world financial system from the peso-style crisis. No single country or agency can handle the potential global crisis alone.
2. National financial transparency may help prevent financial crises. If they know the real economic situation in Mexico, investors would be cautious to invent. It may lead Peso gradually devalue, but would not collapse directly.
3. Mexico should do more saving instead of relying too much on foreign portfolio investment to finance. 4. Mexico as a developing country, it should pay attention to the structure of foreign investment. In 1993, about 80% of Mexico’s foreign investment of 30 billion U.S. dollars was in the portfolio, while only 20% was direct investment.
It led two problems. One is increasing domestic consumption and less saving. The other one is rising domestic inflation and overestimation of Peso, which hurt the domestic trade balance.