This article revisits the topic of Mexico’s recurring crises, originally addressed by the author in the book «Mexico and the Sexenio Curse: Presidential Successions and Economic Crises in Modern Mexico,» written in 1999 and published by the Center for Strategic and International Studies (CSIS), Washington, D.C.
Mexico has endured numerous crises over the past 40 years. The most interesting characteristic of these crises is that there has been one in each presidential term (known in Mexico as «sexenios,» as they last six years) since 1970 to date.1 Some of them have fit the classic balance-of-payments crisis model, due mostly to the presence of large fiscal deficits. In these cases, the transmission mechanism usually started from ever-increasing public-sector borrowing requirements, causing disequilibria in fiscal and external accounts, and finally finishing with large exchange rate adjustments. The crises usually erupted with soaring inflation and a severe recession. Others have fit a second-generation crisis model implicating self-fulfilling prophecy mechanisms. In these cases, crises would result more from negative expectations than from large fiscal and external disequilibria. As of late, however, the crises do not seem to follow any model in particular, but merely seem to keep appearing, making it seem like a true curse that the country cannot escape.
At first, the sexenio curse was defined in terms of a currency crisis occurring either in the last year of the outgoing, or in the first year of the incoming presidential term. Large fiscal deficits were very common throughout the six-year term, leading to important macroeconomic imbalances. Sometimes the president would try to correct the disequilibria prior to finishing his term. When this did not happen, however, the incoming president would face a very difficult environment characterized by capital flight, forcing the new administration to take corrective action that caused the ensuing crisis.
After almost three decades of this behavioral pattern, it seemed that the Mexican government had finally learned that fiscal deficits are not only unsustainable, but also cause near irreparable damage. In fact, the repetitive cycle of crises finally pushed the Partido Revolucionario Institucional (PRI) from office after 71 years of uninterrupted power. One of the worst, and perhaps the most famous crises, known as the Tequila Crisis of 1995, not only led to the defeat of the PRI in the 2000 presidential elections, but also brought about a relentless crisis-prevention policy, carried out by President Ernesto Zedillo from 1997 to 2000, prior to the elections. He pursued a floating exchange rate, a prudent monetary policy and a very low fiscal deficit, carefully avoiding any macroeconomic imbalances. His obsession with avoiding yet another crisis led to investment-grade recognition for Mexico just prior to the 2000 elections. At that moment, it finally seemed that Mexico had broken the sexenio curse.
When Vicente Fox was elected president in July 2000, the Mexican economy was growing above 7%, with a single-digit inflation rate, a healthy balance of payments and a primary fiscal surplus. By the time he took office in December, however, the economy was in recession. While this recession was not characterized by a sharp correction in the exchange rate, increasing inflation or balance-of-payments problems, it did turn out to be the longest in recorded history, lasting a total of 36 months.
Given that all previous recessions had been characterized by currency crises, and basically had been caused by faulty domestic policy decisions, this one was perceived as an exception. It was seen as externally driven, brought on by the U.S. recession that formally started in March 2001. The 2001 U.S. recession, however, lasted only eight months and was shorter than the post-World War II average of eleven months. Why then did the Mexican recession start six months earlier and continue into 2003?
In 2006, when presidential elections once again took place, the economy managed to grow 5.1%, its best performance since 2000. Once President Felipe Calderón took office, however, the economy slowed down significantly and fell into a shallow recession starting in January 2008. There is little doubt that the United States was once again responsible, as it had fallen into recession starting December 2007. Once the Lehman bankruptcy of August 2008 pushed the United States into a much deeper recession, not only did most of the world follow suit, but Mexico’s recession deepened remarkably. In 2009 Mexico’s GDP fell 6.5%, by far the largest decline in all of Latin America, and among the worst in the world. This time the currency depreciated over 50% from peak to trough. But most importantly, it meant that Mexico had not escaped a recession during each presidential term since the 1960s. It seems that Mexico is still plagued by the sexenio curse. The only difference is that now the crises have different characteristics.
The Aftermath of the Tequila Crisis
The eighties represented a lost decade for Mexico. Debt ratios showed Mexico as severely indebted. Fiscal deficits were very high. Inflation reached triple digits and average growth for the decade was basically zero. Although the government carried out far-reaching reforms that helped stabilize the country, progress had not yet been consolidated in the first half of the 1990s. As a result, when many negative political and economic events hit Mexico in 1994, the economy was still very vulnerable to external and domestic shocks. Policy errors made at the end of 1994 and the beginning of 1995 compounded the situation and the so-called Tequila Crisis erupted.
Although the current account deficit was very large and played an important role, the fiscal deficit was not that high. Nevertheless, the government had not been transparent enough with its fiscal accounts. Once off-budget items were brought into the picture, the government’s deficit turned out to be bigger than what had been perceived by the public. The government also lacked transparency with regard to its foreign-exchange reserves, generating much distrust that triggered self-fulfilling prophecy mechanisms that definitely made the crisis much worse than it should have been. In other words, negative expectations erupted, causing capital flight and a large devaluation of the currency. As a result, inflation went from 7% to 52% and interest rates followed suit. Economic activity collapsed by 6.2% and unemployment soared.
Nevertheless, the greatest damage was inflicted on the banking system. Inflation started declining in 1996 and eventually reached new lows. Economic growth averaged 5.5% during the following five years. The exchange rate stabilized and by the next decade the peso gained a reputation as a relatively strong currency. The banking sector, however, suffered irreparable damage: the credit market collapsed and has truly never recovered. The size of commercial banking credit to the non-financial private sector in 2010 is not even 40%, in terms of GDP, of what it was in 1994 and today remains one of the lowest in all of Latin America.
The collapse of the credit market in 1995 brought about an almost systemic bankruptcy of the banking system in Mexico. The system as such survived though, thanks to the costly and controversial measurements taken by the government to restructure, recapitalize and rescue most banks. The legal framework and banking regulations were reformed and strengthened. Foreign capital was the main source used to recapitalize banks and today most banks in Mexico remain foreign owned. The banking system recovered quite well to the point that it survived the 2008/2009 U.S. financial meltdown and its global repercussions. The Mexican banking system posted relatively good profits during this crisis and remains well capitalized.
We must underline, however, a basic distinction between a healthy banking system and credit markets. Banks in general recovered in terms of capital ratios, profit margins, risk coverage and all the fundamental indicators that one looks at to judge a bank. Banks have remained healthy, but have since adopted a very conservative and low-risk approach concerning loan decisions. Many businesses remain wary of banks and look for other sources for working capital. As a result, the credit market as such has never really recovered.
Under previous methodology, direct credit from commercial banks to the non-financial private sector posted a high of 40.9% of GDP in the last quarter of 1994 and reached a low of 6.9% of GDP in the second quarter of 2002. From peak to trough, real direct credit collapsed 78.3% (from December 1994 to April 2002). After eight years of contraction, it finally started growing again in 2003. Nevertheless, at the end of 2009, real direct credit was only 59.5% of what it was at the end of 1994.
Revised methodology (GDP was revised as of 2003 and data are not comparable to previous years) does not allow a true comparison of data before and after 2003. Nevertheless, the numbers are not radically different and the trend remains the same. Still, given that nominal GDP was revised upwards, the size of the credit market as a percentage of GDP is now perceived as smaller. If we use a comparable estimate of nominal GDP under the previous methodology, direct credit stands at around 13.4% of GDP at Q4 2009. Using the revised GDP data, the ratio declines to 13.2%. If we add in the credit given through non-bank financial entities and the assets associated with restructuring programs, the private sector credit market represents 14.1% of GDP. Comparable data for other countries show Brazil at 45%, Chile at 65% and Panama at 94% of their GDPs.
The banking system was privatized between 1991 and 1992, at about the same time that the government managed to balance its budget and thus no longer required financing from banks. This meant that the newly privatized banks were highly liquid and had a lot of resources to lend. As a result, credit to the private sector increased very rapidly in the following years. When the Tequila Crisis erupted in 1995, it found many overleveraged firms and over indebted families facing huge increases in interest payments at a time when inflation was increasing at a much faster pace than salaries. As a result, nonperforming assets of the banking system reached staggering proportions and banks became grossly undercapitalized. The government reacted by implementing a series of policies aimed at avoiding a systemic bankruptcy and salvaging the financial sector.
The biggest miscalculation of the government, however, was in terms of the moral hazard issue behind its efforts. Debtors soon found out that they could stop payments to the bank with few consequences. As a result, nonperforming assets continued to grow and the credit market collapsed. Debtors discovered that legislation was weak, did little to enforce payments and only vaguely protected property rights. This led to a «no payment culture,» a phenomenon that not only destroyed the credit market, but also set a precedent that basically impaired its comeback. While the economy recovered from this crisis, the credit market never really did.
Today, the Tequila Crisis seems just part of Mexico’s history, something that happened long ago and that most people have forgotten. The aftermath of this crisis, however, was the permanent damage it did to the credit market. This is one of the main reasons why Mexico has underperformed in terms of economic growth over the past decade and has an upper boundary on growth going forward.
Many have stressed the absence of crucial structural reforms as the main impediment to higher growth. While most of these reforms (fiscal, labor, energy, political and regulatory, to mention the most talked about) are very likely to help, they are not the main hurdle to better performance. Many countries in Latin America are in dire need of fiscal reforms, labor flexibility and face similar challenges to those faced by Mexico, yet they are growing at much higher rates. Mexico’s biggest limitation is the lack of credit for the private sector, especially for the small- and medium-size firms that do not export and that represent the backbone of the domestic economy.
After a decline of 6.2% in GDP in 1995, the Mexican economy grew an average of 5.5% per annum over the following five years. How can we explain this good performance in the midst of a destroyed credit market? The combination of a highly undervalued currency, the onset of the North American Free Trade Agreement (NAFTA) and a dynamic U.S. economy permitted Mexico’s exports to grow at a double-digit rate between 1995 and 2000. Most of Mexico’s exports are carried out by multinational firms with access to world credit markets and financing from their head offices. At the same time, because of their international position, these firms are considered low risk, which facilitates their access to credit. As a result, they were able to grow quite fast during the export boom and became Mexico’s main engine of growth. Small- and medium-sized firms, on the other hand, did not have access to international credit markets and represented high risk, especially in the aftermath of the Tequila Crisis.
If we analyze Mexico’s growth over the past 15 years, we find not only that the export market has always outperformed the domestic market, but also that non-oil exports are basically Mexico’s only engine of growth. The domestic economy is not strong enough to grow on its own, so that when export demand slows down, the whole economy follows suit. Most foreign investment goes to building up Mexico’s export capabilities and little, if any, is channeled into non-export sectors. Finally, a high proportion of working capital and credit received by small- and medium-sized firms is obtained through other companies that provide lenient payment conditions through the production chain. If the large export firms slow down, this source of credit diminishes.
Over time, Mexico’s dependency on its export market has grown significantly. Mexico’s exports are fundamentally manufactured goods with a high content of imported inputs. Given the high proportion of exports that go to the United States, Mexico became not only dependent on the U.S. economy, but more specifically, on the U.S. manufacturing sector. At the same time, one sector (automotive) represents around 25% of total manufacturing exports. At first, with the introduction of NAFTA, this sector was able to grow quite fast as Mexico captured a bigger share of the market. The automobile sector in the United States, however, is not a high growth market and it is very competitive. As a result, this sector’s contribution to growth has slowed down over time.
The high correlation between Mexico and the United States is not through GDP, but rather through manufacturing production. If we look at the U.S. business cycle in 2000 and 2001, we find that U.S. manufacturing peaks in June 2000 and shows a definite downward trend starting in the second half of the that year, around nine months prior to the official start of the U.S. recession. Mexico’s manufacturing production peaks in July 2000, one month after the United States, but enters into recession in October of the same year, six months prior to the United States.
A similar pattern is observed upon examination of the business cycles over the following two years. U.S. manufacturing reaches a low in November 2001 and then starts growing again. This coincides with the end of the U.S. recession, which officially lasted 8 months. Most analysts agree that the recovery started because of a boost in private consumption, fueled by fiscal and monetary policies. Average growth in 2002-03 in the United States was slightly above 2%, indicating a still relatively weak economy. Manufacturing production, however, grew 3.7% for 7 months (from November 2001 to June 2002) and then stagnated for the following 12 months. The average growth from June 2002 to June 2003 was 0.02%. This stagnation was blamed in part on the corporate governance scandals (WorldCom, Enron, etc.) that brought private investment to a standstill. The U.S. economy did not return to recession, however, given that private consumption sustained a weak but growing economy.
Given that the link between Mexico and the United States is mostly through manufacturing, the U.S. stagnation stopped Mexico from having a formal recovery, and a shallow recession continued until September 2003. The growth in U.S. consumption was enough to lift the United States out of recession, but it was not enough to do the same for Mexico. Another factor that played an important role was the emergence of China as a world manufacturing player, competing directly with Mexico. When the U.S. recession started in 2001, many assembly plants in Mexico were relocated to China (and other places), taking advantage of lower labor costs and other competitive advantages. While South America benefited greatly from the subsequent commodity boom (2002-2008) with enhanced exports, Mexico was faced with greater competition and non-oil export growth was much lower.
To summarize, there is little doubt that Mexico’s 2000-03 recession was induced by the United States. Nevertheless, the pro-cyclical pattern and greater duration of Mexico’s recession compared to that of the United States were more likely due to the absence of a strong domestic economy than to an export sector heavily dependent on the United States. Mexico’s ebullient export capacity has to be seen as an important asset; the lack of credit and a resulting weak domestic economy are the true problems.
Economic growth during Vicente Fox’s sexenio registered an average 2.4%, divided into two distinct periods: the first three years saw an average of 0.7% growth and the last three saw an average of 4.1%. As is common in Mexico, the last year of the sexenio (election year) showed the highest GDP growth rate of Fox’s six-year term, reaching 5.1%. Thus, at least in theory, Fox handed over a relatively healthy economy to his successor. Not only was the economy growing, but inflation was also under control at 4.1%, the current account deficit was quite low at 0.5% of GDP, and the fiscal primary balance registered a surplus of 2.5% of GDP, the highest since 1997. In other words, for the second sexenio in a row, the macroeconomic balance was quite good.
Felipe Calderón took office in December 2006. In his first year in office, signs of an imminent bust in the U.S. housing market appeared. As a result, the U.S. economy slowed down, and more particularly, industrial production decelerated, causing the U.S. demand for Mexican exports to decrease. Non-oil exports grew almost 8% in 2007, about half the rate that they had in 2006. As Mexico’s main engine of growth lost momentum, GDP growth slowed to 3.3%.
The United States fell into recession the following year, albeit, it was a relatively mild one in the beginning. Nevertheless, the Mexican economy slowed even further, registering a growth rate of only 1.3%. As a result, the first two years of the Calderón administration saw an average growth of 2.3%, slightly below the six-year average of the previous sexenio. At the same time, the rest of Latin America was growing at above average rates, benefitting immensely from the commodity boom. Of the 18 largest economies of Latin America, Mexico was showing the lowest growth of all.
The U.S. recession deepened sharply in Q4 2008, when the government allowed Lehman Brothers to go bankrupt. The Mexican economy immediately followed suit and fell into a much deeper recession. Although a trough occurred in May 2009, and the economy began a timid recovery, GDP for the year fell 6.5%, slightly more than the decline registered in 1995. While the first contagion mechanism was through a sharp decline in demand for Mexican exports, Mexico was affected through three additional transmission channels. First, an overexposure to the foreign exchange derivatives market brought about an estimated U.S. $13 billion shortfall in foreign exchange, pushing the exchange rate into a tailspin. Second, world liquidity dried up fast, reducing capital flows into the country and forcing further depreciation of the currency. Finally, both business and consumer expectations were hit hard by the sharp currency depreciation, the retrenchment in liquidity and the deteriorating world outlook.
At the onset of the crisis, Mexico and Brazil were two of the hardest hit countries. Previous experiences with sharp depreciations of the currency had always led to higher inflation, a deep recession and increasing unemployment. Nevertheless, Brazil was able to bounce back quite quickly because of its dynamic domestic economy. Mexico, however, was unable to do the same, given its weak domestic economy, a result of its small domestic credit market. In the second half of 2009 and the first half of 2010, U.S. demand for Mexican exports increased significantly, leading to the start of its recovery. Nevertheless, investment and private consumption have remained stagnant, due to insufficient credit.
The outlook for 2010 in terms of GDP growth looks relatively good. A high GDP growth rate is expected, but mostly because of a very favorable base comparison (economic activity fell substantially in 2009). Once the base comparison effect wears off, GDP growth (in 2011) is expected to remain near 3%. If some of the pending structural reforms (i.e., labor, fiscal and energy) are approved, GDP may do marginally better. Nevertheless, the true and main limit to higher growth is the size of the credit market, something that will not change quickly.
The Curse Lives On
This assessment of the Mexican economy concludes that Mexico’s growth will remain limited until the penetration of the credit market returns to an acceptable level. A word of caution must nevertheless be given to both the banking system and the government. While favorable government policy can help foster the process, credit growth must be carried out at a rate that can be adequately absorbed by the banking system and the economy. Rapid credit growth in the past has led to disequilibrium in many areas, causing major problems. Banks need to worry about nonperforming asset growth, adequate risk provisions and solid capital ratios.
The government’s efforts must focus primarily on reducing systemic credit risks, such as reinforcing the rule of law, improving property rights, implementing adequate deregulation and creating a macroeconomic environment that leads to higher country investment grades. If the government wants to reduce the cost of lending, it must concentrate on reducing the risk factors involved in the credit market. Its current strategy of trying to induce banks to increase lending through moral persuasion is useless. Further regulation placing limits on interest rates or other parameters will most likely impede credit growth and create perverse incentives.
Finally, low credit penetration is not the only factor behind a relatively weak domestic economy. The government must work with the private sector in order to enhance its ability to grow and not pursue policies that crowd out entrepreneurial incentives. Pending structural reforms are likely to help, but must be complemented with measures that induce further private investment.
All statements of fact or expression of opinion contained in this publication are the exclusive responsibility of the author.