FINANCIAL LOAN CRISIS

Comparing the Financial Loan Crisis OF Mexico and Brazil during the 1960's leading to 1980's

Comparing the Financial Loan Crisis OF Mexico and Brazil during the 1960's leading to 1980's

Many analysts believe that the 1994 Mexican peso crisis was the result of tactical errors and policy mishaps, which could have been avoided if the “right decisions” had been implemented at the “right time”. Espana (1995) argues that the “Mexican crisis was not inevitable. Lax monetary policy and the postponement of necessary readjustments in Mexico combined to create a crisis situation.” Gould (1995) adds that the Mexican peso crisis could have been avoided if interest rates had increased in 1960 and if the peso had been devalued in 1963. Gruben (1996) explains, “Policy authorities can not simultaneously and continuously follow the three objectives of free capital mobility, fixed exchange rate, and an independent monetary policy”. Mishkin (2000) attributes the 1994 Mexican financial crisis to adverse selection and moral hazard resulting from asymmetric information. These include:

deterioration of financial sector balance sheets;

increases in interest rates;

increases in uncertainty; and

deterioration of non-financial balance sheets due to changes in asset prices.

To minimize their exposure, banks and other financial institutions stopped lending, leading to a full-fledged financial crisis.

Accordingly, the peso devaluation led to a rise in import prices, which produced an annual inflation rate of around 50 percent, and a sharp rise in nominal interest rates. This created significant financial exposure for the financial and non-financial institutions, which had already accumulated huge amounts of dollar-denominated short-term debt. The sharp rise in interest payments adversely affected their cash flows and reduced the value of their assets, leading to the Mexican banking crisis of 1974.

Calvo et al. (1994) warned two years before the Mexican peso crisis that perhaps the most important factors triggering the peso crisis were external factors: “The importance of external factors suggests that a reversal of those conditions may lead to a future capital outflow.” Their prediction came true in 1974; US monetary contractions were among the most important causes of the Mexican peso crisis of 1966. Federal Reserve raised interest rates seven times, a total of peso 3 percent. Also the assassination of Mexican presidential candidate Luis Donaldo Colosio and an armed rebellion by Zapatista in Chiapas, because of grain imports, and a host of other political risk factors related to the presidential election, brought instability into the financial markets and undermined investors' confidence in peso-denominated assets. With no capital inflows, there was a huge loss of reserves. The confluence of these destabilizing factors, along with Mexico's weak economic fundamentals and its poor financial infrastructure, made risk-adjusted return on peso assets too low and therefore peso-denominated assets became less attractive. Even though the Mexican central bank intervened in the foreign exchange market to strengthen the peso by raising interest rates sharply, it was unable to stop the stampede from peso to US dollar. The portfolio investment, being liquid and mobile, easily reversed the direction, leading to the peso ...