Read the following case and answer the question that follows. In a word, the 1994 economic crisis

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Read the following case and answer the question that follows. In a word, the 1994 economic crisis in Mexico – often referred to as the Mexican peso crisis – can be attributed to overspending. But, as with all crises, there is far more to it than just living beyond one’s means. This story involves rebellion, assassination, fratricide, corruption, money laundering, de-regulation, a lot of investor doubt and a near $50 billion bailout. For the country at least, it has a happy ending. Although the Mexican peso crisis had a long lead-in time, it came to a head rather quickly and was dispatched with equal haste. Following almost a decade of economic stagnation and hyper-inflation, the Mexican government took its first step towards the liberalization of trade when it signed up to the General Agreement on Tariffs and Trade (GATT) in 1986. Deregulation of the capital markets and the banking system followed. In 1992, the ruling Institutional Revolutionary Party (PRI) signed up to reduce trade barriers with the US and Canada through the structure known as the North American Free Trade Area (NAFTA). By the end of 1993, inflation had dropped to 7.05%, the lowest figure in 22 years, and foreign investment was coming in on the back of low US borrowing rates. To the casual observer, the future for Mexico looked rosy. But there was a catch. Not only was growth crawling along at an average of only 2.8% a year, but in the build-up to his final year of office in 1994, Mexico’s President, Carlos Salinas de Gortari, had set out on a vote-winning but unsustainable spending spree. Major investment programs in public health and education were underway which, whilst socially responsible and largely popular, were very public signs of the country’s profligacy. With the new Page | 2 of 7 banking freedom going largely unchecked, the level and quality of lending started to create ripples of concern amongst the domestic and international investor community. This concern was exacerbated by the realization that government spending had expanded the country’s deficit (it went from $6 billion in 1989 to around $20 billion by 1992 when it signed the NAFTA agreement) and it kept on growing. All the while, the peso’s strength was constricting exports and pushing up imports, further widening the gap. It was not long before talk of an overvalued peso started to circulate, in effect signaling the beginning of the end. Adding to international investor concern was a widely held (but not necessarily correct) view that Mexico was undergoing a period of political instability. Chief among the worries was the January 1994 uprising in the state of Chiapas. The Zapatista Army of National Liberation (Ejército Zapatista de Liberación Nacional, EZLN), a revolutionary leftist group, had declared (an apparently largely non-violent) war on the Mexican state. The Zapatistas saw Salinas and his cronies as being out of touch with the will of the people and therefore an illegitimate power. Having failed earlier to secure a popular uprising, EZLN turned its attentions to what it considered to be the divisive nature of Mexico’s signing of the NAFTA agreement, which came into effect on 1st January 1994. The agreement resulted in the removal of Article 27 Section VII of the Mexican Constitution. This had assured land reparations to Mexico’s indigenous people. The New Year’s Day revolt lasted just two weeks, but EZLN’s grievances were well-timed to punish the government by further damaging the country’s risk profile in the eyes of the investment community, putting a higher premium on Mexican assets. With a sick budget deficit and a current account deficit (now standing at 7% of GDP) fueled by excessive consumer spending and what was now clearly an over-valued peso, Salinas’ government needed to find funding from somewhere. It issued the tesobono (treasury bill), a debt instrument denominated in peso but indexed to (and paid out in) US dollars. And then in March 1994, in the build-up to the election, came the assassination of Salinas’ intended political successor within PRI, Luis Donaldo Colosio. PRI had been the dominant force in the country for more than 60 years and it looked very much like Colosio’s election would be a shoo-in. Salinas’ eventual PRI successor, Ernesto Zedillo, did win in that August’s election, but just one month later, on 28thSeptember 1994, the party’s Secretary General (and Salinas’ brother-in-law), José Francisco Ruiz Massieu, was also assassinated. To all intents and purposes, Mexico looked to be in a state of heightened political instability and funds started to make a quick exit, further damaging the economy. Ruiz Massieu’s untimely death (untimely in more ways than one) was later found to be at the hands of Raúl Salinas, the president’s brother, with Ruiz Massieu’s own brother, Mario Ruiz Massieu, also implicated. The latter’s name was linked to bank accounts containing some $17m in what appeared to be an attempt at money laundering. Mario Ruiz Massieu committed suicide in 1999, his suicide note blaming Zedillo for both his own death and the assassination of his brother. With each successive damaging blow, tesobono investors were offloading them like they were going out of fashion – and they were. Paying out in dollars further depleted the already low central bank reserves (these hit a reported record low of $9 billion). In order to maintain the fixed exchange rate (set at 3.3 pesos per dollar) pushing up interest rates would perhaps have been a prudent move. But it was election year, and so the central bank, Banco de México, under Salinas’ direction, instead depleted its reserves by getting heavily into Mexican treasury securities. Page | 3 of 7 With inflation having soared to over 50% as his tenure was coming to an end, Salinas knew that the game was up. But he was absolutely determined not to devalue the peso on his watch. In trying to support the country’s currency, Mexico deployed yet more of its hard foreign currency holdings, an act which cost it dearly. Nonetheless, devaluation of the peso was inevitable. When it finally came, on 22nd December 1994, the loss of face fell to Zedillo’s government which had only assumed power 22 days earlier. Initially, Zedillo had broken an electoral promise and reversed the Salinas administration’s attempts to keep the fixed rate peso-dollar rate by allowing an increase of the rate band to 15%. Apart from skating on political thin ice, economically this was too little, too late. Letting the rate float saw the peso plummet from 4 pesos per dollar to 7.2 pesos per dollar – within one week. According to the Institute for International Economics, commenting on the ‘macroeconomic policy mistakes’ that led to Mexico’s crisis, the announcement of the intended devaluation was unwisely made mid-week, leaving the government powerless to stop foreign investors abandoning the Mexican market until the following Monday by which point, of course, the damage had been done. Salinas later blamed Zedillo for the outcome, citing his successor’s ‘inept’ handling of the situation, referring to it as ‘el Error de Diciembre’ or ‘the December Mistake’. Just as EZLN’s uprising was short-lived but damaging, so too was the Mexican peso crisis. The US, under Bill Clinton’s leadership, stepped into the breach almost immediately. It started by buying pesos in the open market. It then created a package via the US treasury’s Exchange Stabilization Fund (as opposed to having the US central bank intervene directly, Clinton having failed to get his Mexico Stabilization Act passed by Congress). The deal also involved the Canadian central bank, the IMF and the Bank for International Settlements, all guaranteeing Mexico’s loans and reported to be worth in the region of $50 billion. In less than 18 months, the Mexican economy was on the up. Between 1995 and 2000, the annual rate growth averaged 5.1%, with GDP growth at 5.5% by 2010 (based on figures from national newspaper, El Economista). According to IMF figures, as of March 2011, foreign reserves were $128.299 billion and nominal GDP in 2012 stands at $1.231 trillion. The World Bank places Mexico as nominally the 13th largest economy in the world.

Question:

Use the above information to critically analyze the government possible intervention in the foreign exchange market, highlighting possible rationales of intervention, different types of interventions, tools of intervention, and most importantly the potential effect(s) of intervention. Relate your answers to the case of the Mexican peso crisis as much as you can.