Peso Crisis

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...