Mexico maintained a fixed exchange rate of 12.50 pesos to the dollar until 1976.  To accomplish this, the Banco de Mexico actively intervened in the currency market to keep the peso at the desired exchange rate.  The central bank would use its foreign currency reserves, usually dollars, to buy pesos.  This decreases the supply of pesos on the market and increases the supply of dollars, making pesos more valuable relative to the dollar.  A main reason for this is to maintain the purchasing power of the peso in order to keep imports affordable.

On the other hand, if the peso is perceived to be overvalued, the bank will sell pesos in exchange for dollars, driving the value of the peso down.  Mexican exports will be more attractive with a weaker peso.

Despite continued economic growth in Mexico in the 1970s, budget deficits and inflation were rising, and deficits were financed through foreign debt.  A precursor of problems to come, the peso was devalued by 56% in 1976 and taken off its fixed exchange rate in favor of a managed floating rate.  In the managed floating rate system, the peso would be allowed to move within a band which would be enforced with central bank intervention.

The Mexican government, expecting increasing oil revenues from high world prices, increased borrowing in dollars.  However, oil prices plummeted in the early 1980s, greatly reducing revenues and dollar inflows.  Declining international economic conditions decreased demand for Mexico’s primary exports.  Foreign capital, made nervous by the growing debt, began to leave Mexico, putting downward pressure on the now overvalued peso.  These dollars had been used to service the growing Mexican debt, and in their absence the government announced in 1982 that it could not service its debt on billions of dollars of loans.

Neoclassical economists developed the Monetary Approach to the Balance of Payments (MABOP) theory to explain the cycle indebted Latin American countries found themselves in during the 1970s and 1980s.  According to MABOP, budget deficits contribute to inflation since it is known they will eventually be monetized.  Devaluations of a currency do not keep pace with inflation, leading to overvalued exchange rates.  Exports fall while imports rise, leading to a trade deficit and capital flight.  Governments must borrow to finance the balance of payments deficit, which leads to high interest payments.  Each step of the cycle makes the next step worse and the cycle is perpetuated until the government must capitulate and devalue the currency.

Miguel de la Madrid came into office in 1982, inheriting an economy in crisis and in serious need of reform after years of government intervention.  The first order of business was to tackle the near 100% inflation rate.  The government was able to slow inflation to around 65% by 1985 through spending cuts and tighter monetary policy, but at the cost of a 13% decrease in GDP over the same period.  Another top priority was government debt reduction, which resulted in net transfers through debt payments to foreign creditors of 6% of GDP between 1982 and 1985.

Despite publicly claiming to control inflation, the government was incentivized to inflate the money supply through the existence of an “inflation tax”, which is the wealth transfer from holders of cash to the spender of newly created money, in this case the government.  Money creation was such that this course of action equated to up to 8% of GDP between 1983 and 1985.  By 1986, inflation had returned to its 1982 level of near 100%.

The Mexican government was still heavily involved in the economy, controlling the banking sector and limiting foreigners’ ability to invest in Mexican businesses.  Government debt and controls had smothered the economy, causing a drop in per capita income in the 1980s almost as large as that seen in the Depression.  Clearly, a freeing of the economy through free market policies was in order.

In 1987 and 1988, the Mexican government signed two agreements with the business, labor, and agriculture sectors popularly called the Pacto, which through its various incarnations has attempted to curb expansionary monetary and fiscal policies, control prices and wages, renegotiate debt, deregulate markets, and privatize state-owned businesses.

The Mexican public sector owned 1,155 businesses in 1982, and by 1994 940 of those were divested.  The tax system was simplified, rates were decreased, tax collection and tax revenue increased, and government spending and fiscal deficits fell.  The government also implemented financial and trade liberalization.  The elimination of bank reserve requirements and mandatory financing of public sector businesses removed a heavy burden from private finance and allowed capital to flow to more productive areas in the economy.  Banks were privatized, capital controls were lifted, and foreign capital was allowed greater access to Mexican investment.  Trade liberalization came in the form of reduced import licensing and tariffs, and was codified with the passage of the North American Free Trade Agreement (NAFTA) in 1993 (Gould, 1995).

Mexico’s economic liberalization programs and successful foreign debt renegotiation in 1990 attracted capital inflows, which were made more attractive by the low interest rates seen at the time in the U.S.  The financial sector’s unburdening resulted in rapid credit expansion, made possible by a large reduction in public debt and a rise in the Mexican stock market and real estate prices.  Expectations of economic growth and an abundance of foreign and domestic capital led to decreased lending standards which, when faced with an economic slowdown in 1993, resulted in a rapidly increasing number of non-performing loans on the books of Mexican banks.

Local Mexican commercial banks increased credit to the private sector by an average of 25% per year from 1988 to 1994.  During this same period, credit card debt rose 31% per year and mortgage loans rose 47% per year (Gil-Diaz, 1998).  This local credit expansion combined with large foreign capital inflows led to rising aggregate demand within Mexico and a strengthening peso which could only lead to a current account deficit.  Unfortunately, the Pacto contained within it a commitment to keep the exchange rate within a narrow band that was not in harmony with the current heated economic conditions.

With foreign money spurning low U.S. interest rates in favor of higher Mexican rates, largely in the form of short term capital, money flowed into Mexican markets.  The Banco de Mexico acquired an increasing supply of dollar reserves and was able to provide the needed pesos to the market.

Predictably in an environment inundated with foreign capital and easy credit, leveraged investment began to flow to less productive projects chasing returns, increasing the fragility of the economy and leaving it vulnerable to changing international investment conditions, which occurred when U.S. interest rates rose, decreasing the demand for peso denominated investments and exposing the multitude of bad loans on the books of Mexican banks (Kaplan, 1998).  As investors began to demand dollars in exchange for pesos at the managed exchange rate, Mexico’s foreign reserves began to shrink to the point that peso devaluation became necessary.  The peso/dollar exchange rate went first from 3 to 3.5 pesos to the dollar, with the managed currency band still in effect.  This move did not end speculative pressure on the peso, and the government increased the peso’s band.  With pressure mounting, the government was forced to capitulate totally on December 22, 1994 by removing the peso’s managed float and allowing the currency to move freely against the dollar.  This effectively devalued the peso from four pesos to the dollar to 7.2 pesos to the dollar in one week’s time.  The U.S. government began buying pesos in an attempt to stop a collapse, and then put forth $50 billion in loan guarantees to Mexico, which were accepted and repaid ahead of schedule by 1997.