Mexico: A Beginning of the Debt Crisis in 1980’s

1980’s was a watershed period for the Latin American economies especially Mexico that faced major financial and economic crisis from the late 1970s to 1980s. It is often known as the period of lost decade due to defaulting on sovereign debt by Latin American countries.

The crisis culminated due to mismanagement of fiscal and monetary policies of different government regimes of Mexico that proposed such policies.

Post World War II, Mexico followed an economic policy based on Import Substitution Model (a model that focused on internal development strategy by limiting the imports and encouraging regulated domestic markets in the country). Thus, from 1954 to 1972, Mexico claimed to have an era of Stabilizing Development (SD) or Mexico Miracle. It was a period of high economic growth and low inflation (3.5%). The major economic policies were introduced under President Miguel Alemán Valdés’s (1946-52) to maintain an overall price stability and a fixed exchange rate (fixed at 12.5 pesos per dollar). It allowed an economic structure that included private capital accumulation to stimulate industrial expansion along with high growth rates of agricultural output.

The high economic stability underwent a radical change under the presidential administration of Luis Echeverría Álvarez (1970-76). Under his regime, expansionary fiscal policy increased public spending in social development projects. In the succeeding five years, general government employment doubled and the share of total public sector spending in GDP jumped from 20.5 percent to 30 percent.

However, according to macroeconomic principles, as much as expansionary fiscal polices increase the aggregate demand that in turn helps in increasing the employment rates in the economy and high economic growth, if undeterred at the full capacity of the economy, it can cause high rates of inflation and fiscal deficit. Consequently, inflation rose above 20% in 1973-74 and another side effect of the fiscal policy was the crowding out. Since the government spending concentrated in the public sector, it led to a negative impact on private investment that slumped from 14 percent of GDP (at 1970 prices) in 1971 to 12.7 percent in 1975. The situation worsened with the disequilibrium of the balance of payments that led to a current account deficit of $4.4 billion in 1975.

Thus, Álvarez’s economic policies were a complete failure. Under his regime GDP grew at only 3.1%, slightly less than 3.7% under previous governments. An expansionary fiscal policy with high spending on education and other productive projects helps in long-term productivity. But the government failed to make such projects, as the priority was more on state-owned enterprises. The deterioration of the balance of payments led to a sixty percent devaluation in the peso at a fixed exchange rate of 12.5 peso per dollar.

Mexico was predominantly an agricultural economy with phases of industrial expansion undertaken by the government and a net importer of oil but this changed under President Lopez Portillo.

Years Real GDP per capita growth Inflation Current Account Deficit
1954-72 3.7% 3.5% -1.5%
Post 1972 3.1% 20% -2.9%

Source: IMF

In 1976, due to several unstable economic pressures, President Lopez Portillo replaced the political regime of Álvarez. To overturn the economic situation, Portillo made an arrangement of a stabilizing program of fiscal austerity with the IMF under Extended Fund Facility over the next three years (1976-79).

Positive Impact of IMF Intervention Pre 1976 1979
Fiscal Deficit (%of GDP) 9.9 6.7
Inflation (%) 27.2 20
Current Account Deficit $4.4 billion $2.2 billion

Source: IMF

The IMF intervention helped Mexico regained its reputation as one of the promising developing countries. The main reason for this positive impression was the two oil shocks in 1970’s and the discovery of oil reserves in Mexico. This placed Mexico in an advantageous position because in the period of oil shocks, Mexico became the primary exporter of oil. Moreover, the developed countries like the US encouraged by Mexico’s successful stabilizing program and economic growth extended bank loans to Mexico.

However, Portillo’s administration entered in an economic quagmire where rampant corruption and mismanagement prevailed and soon buoyed by the oil wealth, the IMF program was dropped and replaced by new expansionary fiscal policies. This was one of the first mistakes in the policy implementation due to the over optimistic picture of oil revenue wealth that eventually led to a fiscal deficit.

The new policy continued the Álvarez’s Public Expenditure-Led Growth (PELG) plan that entailed large development plans to increase real government spending. It also stimulated private sector investment from 11.7% to 14.1% in 1981.

The expansionary fiscal policies led to following changes:

Years From 1976 To 1981
Real GDP per capita (in US $) 4,973 6,467
Real GDP growth rate (%) 6.82 0.91
Inflation 27.20 28.61

Source: IMF

Though the policy reform led to some changes, it didn’t bring about a structural economic change. The inflation began to increase from 1978 and reached to high levels of 28.61% in 1981.

By early 1981, the share of Mexican oil market and export prices of oil began to decline, as the world economy entered a recession. This led to a sharp increase in the interest rates on short-term loans in contrast to near zero interest rates that the US commercial banks offered Mexico earlier. However, without analyzing the risk of borrowing more loans, the national oil company, PEMEX in the hope of continued demand for high quality of oil exported it without lowering down the prices.

The increase in fiscal deficit was offset by the reluctance of the banks to lend money and borrowed only at high interest rates. From 6.7% (in GDP), the overall fiscal deficit grew to 14.7% in 1981. By the end of 1982, the foreign debt grew to $81 billion. Inflation increased with an annual rate of 100 percent and real per capita GDP declined 8.1 percent.

In late 1982, Mexican Finance Minister Jesús Silva Herzog revealed the situation of the unsustainable debt crisis and that Mexico failed to service its debt to the lenders. The revelation brought out a bigger picture of the World debt crisis in 1982 and the incautious approach of the commercial banks to extend loans without considering the high risk of deficit involved. It also marked the end of new foreign lending and Import Substitution Model in Mexico.

Several efforts were made to leverage the economic situation that was marked by rising stagflation, high interest rates, and increased outflow of money from Mexico. Portillo responded by nationalizing the banks, introduced a system of exchange control, and devalued the peso by more than 260 per cent.

With the end of Portillo’s regime, the new President De La Madrid, restarted the structural reform program with IMF and with it Mexico’s economy set on a transition from ISM to the neo-liberal model of economy. Fiscal discipline was rigidly enforced and the consolidated public sector deficit relative to the GDP was halved from 17.6 percent to 8.9 percent. Drastic measures were taken to expand the export earnings and cut back the imports. This helped in trade surplus that rose to $12.8 billion.

Years From 1982 To 1985
Inflation (%) 98.87 63
Real GDP per capita growth rate -8.12 1.76

Source: IMF

However, such reform policies could not reduce the inflation rate that accelerated to 105% post 1985. The causes of the rising inflation were the contraction of domestic output and continued devaluation of the peso. Moreover, the situation worsened with another oil shock in 1986 and two earthquakes in Mexico post 1985. As the fiscal policies provided hardly any improvement in the economy, two Pacts- Pact for Economic Solidarity and Pact for Stability and Economic Growth were signed in 1987 to introduce a fusion of orthodox fiscal and monetary policy with income policy (limiting of the nominal wage increase to control the inflation) in short-term phases.

Hence, the economic changes along with the government policies moved Mexico to make a transition from inward-looking development strategy to outward and open market policies. The periodical fluctuation in the inflation and current account deficit rates show that poor policies of the government without considering the precautions and risks of the fiscal policies can have a negative impact on the economy along with the impression of distrust in foreign markets.

Bibliography

  • Buffie, Edward, and Allen Sangines Krause. “Mexico (1958-86): From the Stabilizing Developement to Debt Crisis.” Developing Country Debt and the World Economy (The National Bureau of Economic Research), 1989: 141-168.
  • International Monetory Fund. “The Mexican Crisis: No Mountain too High?” The Crisis Erupts 1982.
  • Gould, David M. “Mexico: Looking Back To Assess the Future.”
  • Kim, Kwan S. “Mexico: The Debt Crisis and Options for Development Strategy.” (The Helen Kellogg Institute of International Studies) September 1986.

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