Impacts of Mexican crisis

By J.E. Ismael

The following article is based on a paper presented before the 30th Southeast Asia Central Bank Governors Conference held in Manila recently. This is the first of two articles.

MANILA: The world has experienced an unprecedented monetary event: the peso crisis in Mexico. Now that five months have passed since the crisis occurred, we can examine it with some perspective. What implications the Mexican crisis will have on emerging economies in the future. What structural changes have occurred in funds flowing into the emerging economies, and what are the implications of those changes.

The Mexican crisis is the most recent manifestation of these structural changes. The occurrence in Mexico has educated market participants and I will discuss the implications of this education.

Finally, I will review how I believe the Mexican crisis will affect investor behavior and the flow of funds to emerging economies in the future.

The Mexican crisis is not the only major economic event this year. The rise of the yen and the failure of the major reserve currency countries to develop a coordinated approach to the rising yen is of major importance to the emerging economies and I will touch briefly on this recent set of events.

With the aid of hindsight, we can now understand what happened in Mexico. Mexico had a large deficit outflow in its balance of current accounts. Investment inflows were not converted into sufficient productive resources to correct this problem over time and were more than offset by consumption of imported goods.

Political instability during 1994, combined with rising U.S. interest rates, adversely affected foreign investment inflows. In spite of the reduced investment inflows, the Mexican government maintained a high fixed exchange ratio, draining foreign exchange reserves. A feature of the Mexican monetary regime was short-term dollar-linked securities called Tesobono, which were Mexican sovereign obligations held by foreign investors.

In December, 1994, the new Mexican government did not communicate effectively with large institutional investors, who suddenly realized that Mexico had depleted its foreign exchange reserves and was facing a less-than-orderly devaluation. As these investors attempted to sell securities and demanded repayment for their dollar-denominated Tesobono, the peso and all Mexican securities denominated in pesos or dollars, fell dramatically.

Investors reacted by withdrawing funds from other emerging markets, and the value of securities and funds flowing into these markets immediately dropped, with the financially damaging effects on the rest of Latin America. This has come to be known as the Tequila effect. In addition, a short-lived contagion impact occurred on some Asian emerging markets.

A student of Mexican political and economic history would quickly point out that this is not the first Mexican financial crisis. Mexico's 1968 crisis, precipitated by student demonstrations and the firing by security forces on the demonstration, was much more severe than anything that has occurred recently in Mexico.

In 1994, Mexico was faced with a sudden loss of international liquidity. If the U.S. and the International Monetary Fund had not intervened, Mexico might have realized disruption of trade, a collapse of the banking system, and devaluation of the peso, with accompanying inflation that would have been far more accelerated than what occurred in 1968.

A few years ago, private capital flows from developed countries to developing countries took two forms: direct investments by industrial or service companies in their respective sectors in the developing country, or loans by large foreign banks in the developing country. Corporate investments were long-term strategic involvements by corporations of developed countries. Bank loans to companies or sovereign borrowers were held to maturity.

However, trends in developed countries, resulting in part from the increasing sophistication of investors and in part due to stresses in lending institutions, have led to increased security for all investments.

For example, enterprises in emerging markets now borrow directly in the international debt securities market. Projects, which once could only be financed through bank loans, are today funded through public offerings of debt and equity sold on domestic and international capital markets. These investments are liquid and need not be held to maturity, but can be sold or even sold short by financial institutions or hedge funds.

Making investments secure is perhaps the single most important fundamental change in the flow of funds in the past decade. Today, even commercial bank loans are traded. In the U.S. in 1994, for example, US$20 billion in bank loans were transacted by the trading and syndication desks of U.S. commercial banks.

Bank loans have become a quasi security with these loans now rated by Moody's Investment Services. The U.S. bank loan trading market has allowed U.S. banks to balance their portfolio size and exposure. Banks which have financial problems can readily reduce their assets through this market. Brady bonds, for example, became a principal vehicle for transferring ownership of doubtful debts between banks and other investors. Therefore, holders of bank loans can now add to selling pressure in markets as investor sentiments change.

Hedge funds are large pools of unregulated capital which invest in money and capital markets, and are estimated to total $80 billion under management, in that the trading desks of commercial banks and investment banks can emulate the behavior of their hedge fund clients and take similar positions.

Because these funds can take short positions, the effect on a security's price or the pressures on a central bank defending an exchange rate are exacerbated. The increased security of markets and the increased presence of hedge funds in these markets have added significantly to market volatility.

Hedge funds have played an important role in the security of bank loans. Loans to distressed enterprises often are purchased by hedge funds at significant discounts of the face value. The hedge funds then sell the equity of the enterprises as the enterprises are reorganized by way of exchanging equity for debt.

The recent Mexican political crisis was made potentially more serious than previous crises by the simple change that investors, who did not understand or were uncomfortable with their understanding of the Mexican situation, could individually sell or withdraw from investment funds, causing the portfolio managers to sell in order to generate liquidity to meet such redemptions.

This effect was magnified by speculative behavior of hedge funds and other institutions. The decline in confidence made it very unlikely that Tesobono could be rolled or refunded, resulting in an unparalleled liquidity crisis for Mexico. Unlike past crises, where the U.S. government and the governments of other developed nations could put political pressure on any bank seeking a rapid repatriation of funds, no political pressure could be put on the millions of individual investors or their fund managers to continue to invest funds or to withdraw in an orderly basis.

The security of global investing and the potential effects of a sudden change in investor sentiment have important implications for all emerging countries. From the institutional or sophisticated investor point of view, Mexico lacked "transparency." Transparency provides the investor with the ability to clearly understand all elements of the investment environment. If you cannot follow or understand the situation, it is better to sell and take your losses rather than be subjected to potentially greater losses. Transparency is inextricably linked to the credibility of the issuer providing confidence to the investor.

From the standpoint of foreign investors in Mexico made nervous by political assassinations and political unrest in Chiapas, they were caught by surprise by their lack of knowledge of the level of foreign reserves and the heretofore unanticipated risks attendant in the sudden depletion of reserves.

The investors suddenly realized that they did not fully understand the political dynamics and policy making process of the Mexican government. They then sought to sell their Mexican investments and take their converted currencies home or to a better investment environment. Mexico lacked transparency and suffered the consequences. The irony of the situation is that apparently, even before foreign investors began to withdraw their investments, the first money to leave the country was formerly repatriated Mexican capital.

Window: From the institutional or sophisticated investor point of view, Mexico lacked "transparency".