Mexico: What's Next?
Remarks by Christopher Whalen[1]
Council on Foreign Relations
New York, N.Y.
March 6, 1995
This
morning I will give you my assessment of the political and economic situation
in Mexico. I first propose to briefly
review the important developments of the past year and look at the current
situation facing the government of President Ernesto Zedillo, then make some
general predictions about the financial and social developments that we will
see in Mexico in 1995 and beyond.
There
is a great deal of debate in Washington about whether or when members of the
Clinton Administration knew or should have known about the impending collapse
of the Mexican peso on December 21, 1994.
Speaking as someone who watches Mexican developments full time and who
warned of the unstable nature of the "Neoliberal" economic model
early on,[2] let me just say that the financial meltdown that has
been called the "Tequila Effect" was inevitable and obvious to anyone
who bothered to read the Mexican press.
One
of the best selling books in Mexico over the past several years, called simply
"Devaluation 1994?", details the nasty implications of the impending
devaluation of the peso. And there are
the obvious examples of leaked memos from within the U.S. government that show
at least some of the people responsible for American financial policy knew
about the impending crisis that has damaged many smaller markets around the
world. It seems to me those American
leaders in politics and finance who claim to have been "surprised" by
the peso devaluation are either confessing gross incompetence or are being
disingenuous.
It is
useful to think about Mexico as being comprised of three spheres or sectors of
economic activity: the productive sector, the speculative sector and the
criminal sector.[3] Let's
consider the results of six years of economic reform under Carlos Salinas de
Gortari:
1. The productive economy, excluding the
small in-bond or maquiladora sector,
has shrunk in terms of the total number of jobs and private sector companies.[4] Dislocation
in rural areas of Mexico has been massive, resulting in literally millions of impoverished
people being driven from the land and into already crowded Mexican cities, a
rising flow of desperate people who must eventually move north. High real interest rates and confiscatory
taxation have made it impossible to support most types of productive business
activity. Like Venezuela, defaults on
business and consumer loans are rising very rapidly and the austerity measures
being implemented by the Zedillo government at the behest of foreign creditors
will only exacerbate credit quality concerns.
On an aggregate basis, the Mexican banking system is clearly insolvent
and cannot survive in its present form.
It is very likely that many if not most of the recently privatized
Mexican commercial banks will require government assistance before year-end.
2. The speculative economy, fueled by
inflows of cheap dollars, inflated to vast size between 1990 and 1994. Now this process is moving in reverse as the
collapsing prices for stocks, bonds and the peso destroy billions of dollars in
wealth and reduce consumer purchasing power.
By shifting the dollar borrowing necessary to finance imports -- and
thus political stability -- from the public to private sector since 1989,
Salinas and his cronies in the previous government cleverly made Mexico's
economy seem larger through new dollar
inflows, while leaving the ultimate liability with the private sector. The economic policies of Carlos Salinas
emphasized raising billions of dollars in new foreign debt rather than boosting
exports and job growth. The result is
an economy that has more debt and arguably less ability to generate dollar income than it did in 1989. Once again, as in 1982, Mexico is in trouble
because of excessive offshore borrowing and spendthrift economic policies, not
because of a short-term liquidity problem, as the Clinton Administration
suggests.
3. Finally we come to the criminal
economy, by far the largest of the three sectors, which is built around
narcotics trafficking, arms smuggling, kidnapping and other forms of illegal activity. The criminal economy has mushroomed in size
and now clearly dominates the entire political landscape. Today, the $20-25 billion in profits from
the $100 plus billion-per-year narcotics trade is twice the total revenues of the Mexican oil sector. Drugs are not simply a threat to the
authority of the Mexican government, as even U.S. officials now grudgingly
admit. Rather, as in the case of Colombia
and Venezuela, narcotics has come to permeate all aspects of Mexican official
and even private life. It is frequently
impossible to do business or even live in many parts of the country without
making a compromiso with the warlords
who govern the narco system.[5] My friends
and colleagues in the political opposition, both on the left and the right,
report that the drug lords and their allies in the government apparatus are now
the ascendant political force in border states like Baja Norte, Sonora, and
Cuahuila, and in many other parts of the country.
In
purely financial terms, the Mexican meltdown signals the end of the latest
cycle of offshore investment in Latin America, a reversal of falling monetary
tides between 1989 and 1994. But the
financial collapse of the past two months has as much to do with changes in
U.S. interest rate policy as with the peculiar relationship between Washington
and the nations south of El Paso. The
real blame for the Tequila Effect and the extraordinary accumulation of new
debt by Mexico -- which totaled some $160 billion in offshore obligations as of
year-end 1994 -- largely belongs with Washington.
Foreign
investors began to withdraw dollars from Mexico last year as a result of (1)
several drug-related political assassinations, (2) the Indian rebellion in
Chiapas and (3) the obvious fact that Mexico was borrowing excessively in order
to finance its huge imbalance between imports and exports. The collapse of Grupo Havre last year, the
subsequent failure of the Cremi-Union banking group, and even the decision by
the Federal Reserve Board to raise interest rates in February last year,
constituted clear warning signals that the proverbial party was over. With a current account deficit of $30
billion for 1994, Mexico's use of debt to finance consumption rather than
capital investment proves that this latest episode was a Ponzi Scheme, not an
exercise in free-market renovation.[6] Indeed,
Mexico under Salinas gives free market economics a bad name.
One
of the great misconceptions in the financial community is that the Mexican
decision to devalue the peso was a bad but voluntary choice; an active
determination rather than a necessary reaction to the reality of suppressed
inflation and dollar-insolvency.
Respected thinkers ranging from Senator Phil Gramm (R-TX) to Robert
Bartley, editor of the Wall Street
Journal, bemoan the fact that the Mexicans followed bad advice and
"decided to devalue the peso."
In fact, the Banco de Mexico
bank ran out of money -- that is, dollars
-- and was forced to devalue. This same
inexorable process is now underway far to the south in Argentina.
Over
the past five years, Wall Street analysts have spent hours pouring over
internal monetary data, financial results for private companies, and other
local currency indicators from the Latin debtor nations. I would argue that
when looking at any emerging market, the exchange rate and the commercial
account are the only two indicators that really matter. If the developing country has a relatively
balanced trade relationship with the rest of the world or even runs a small
commercial surplus, as in the case of Chile, then the currency is probably
fairly valued and the chances of default are relatively small. Then and only then does it make sense to
give great weight to local measures such as money supply growth and company
earnings.
In
the case of Mexico and, to a lesser degree Argentina, however, the inflows of
foreign "capital" have been used not to create new, productive assets
that generate exports, but instead have simply created new dollar obligations
for which there is no clear source of repayment. The existence of a currency board in Argentina, for example,
provides short-term stability, but the fact remains that the present, 1:1
exchange rate of the Argentine peso against the dollar has been financed with
offshore debt, privatizations and other non-recurring hard currency inflows,
and is thus unsustainable.
Today,
as in 1982 and 1989, the chief external issue facing Mexico in 1995 is foreign
debt, not trade. Stripped of the glib
rhetoric of the past 5 years, we find a Mexico that has an economy with a GDP
of less than $200 billion, that generates barely $20 billion in net exports
(including oil sales but excluding the in-bond maquiladoras) but that must somehow come up with something like
$25-35 billion this year in foreign debt service.[7]
Perhaps
more importantly, the peso crisis of 1995 marks the end of Washington's
decade-long effort to maintain the illusion of political stability in
Mexico. The internal political scene is
driven by a new and increasingly unstable factor, namely the ongoing struggle
toward a more free, open, and democratic political formulation. Hopefully it is now apparent to all
concerned that Mexico's political shortcomings caused the present financial
problems.
Thomas
Jefferson said that a free society requires a little bit of revolution from
time to time, but I doubt that Mexico's political opening will be either
violent or anti-American. Indeed, the
process should work to our great advantage if Washington can end, once and for
all, its mindless support for the world's oldest and most corrupt authoritarian
system. Investors and political leaders
in Washington need to get accustomed to the idea of political change in Mexico,
change which must inevitably mean an end to single-party rule as the opposition
parties on the left and right gain greater power.
Despite
its many unique aspects, Mexican society is now in the midst of a citizens
revolt not unlike the broad-based political opening seen in Central and Eastern
Europe, and even here in the U.S. last November. The relatively peaceful revolution that is now underway in Mexico
traces its origins not only to the New Year's Day 1994 rebellion in Chiapas,
but to years of electoral fraud, corruption, official tolerance of narcotics
trafficking and other types of official abuses by Mexico's single party state.
During
a recent meeting of Washington activists, it was suggested that the peso
debacle might offer protectionist factions in the U.S. and Mexico an
opportunity to renegotiate NAFTA, but I respectfully disagree with this type of
thinking. For the time being, NAFTA as
it refers to a new market for significant quantities of U.S. goods and services
is dead. The cash flow that made Mexico
seem like a market for American goods has disappeared, leaving behind a great
deal of work for firms such as Legal Research International. So long as foreigners lent Mexico money, the
mirage of demand for foreign goods was maintained. Now, debt and immigration, not trade and investment, are the two
issues that will dominate the U.S.-Mexico relationship in the years ahead.
What Next?
Let
me close my remarks with a few thoughts about what we may or may not see in
Mexico during the rest of this year:
u Politically
speaking, the situation facing the government of Ernesto Zedillo is complex and
very dangerous, including a threat to the personal safety of Zedillo
himself. I want to applaud and
encourage the steps taken by President Zedillo to deal with Mexico's financial
crisis and, most recently, by arresting Raul
Salinas de Gortari, the older brother of former President Salinas.[8] Zedillo is currently involved in a desperate internal struggle
with the forces of reaction in Mexico, including Salinas, former Agriculture
Minister Carlos Hank Gonzalez, and
other dinosaurios in the PRI old
guard -- the same people who are suspected of engineering the murder of Luis Donaldo Colosio almost a year
ago. So long as the case against Raul
Salinas is confined to the murders of Jose
Ruiz Massieu and Colosio, then the move by Zedillo will be a political
affair to determine how independent Zedillo will be of reactionary elements led
by Carlos Hank and Carlos Salinas. If
the investigation begins to examine the vast corruption of which Raulito was the chief nexus on behalf of
his brother and his father, Raul Salinas
Lozano, then Zedillo will be declaring civil war on many powerful warlords
who have the capacity to directly threaten Zedillo and members of the
government loyal to him.
u In
terms of the larger tactical situation facing the PRI around the country, the
ruling party has suffered a grievous political blow due to the peso
devaluation. The precipitous drop of
the peso has hurt the possibilities for the ruling party in future state and
local elections, even though public support for Zedillo himself has risen since
the arrest of Raul Salinas. The recent
election victory by the conservative PAN or Accion
Nacional in the important central state of Jalisco came about for three
reasons: (1) public anger over the 1993 assassination of Cardinal Juan Posadas, (2) the political
disarray and corruption of the PRI inside
the drug ravaged Pacific coast state, and (3) general public dismay over
the collapse of the implicit pacto
between the government and the electorate.
In a very real sense, the people of Mexico cast their votes for Ernesto
Zedillo in August of 1994 thinking that they were buying political and
financial stability from the PRI. Now
it is shown that the very ill effects of devaluation and political conflict
that were attributed to a possible opposition victory have, in fact, come about
under the PRI.
u Financially,
Mexico faces the inevitability of private debt defaults during 1995 and the
very real possibility of a public sector debt default, particularly if the U.S.
government goes through with its threat to seize the country's oil revenues if
a default occurs on the $20 billion loan facility provided by the Treasury and
Federal Reserve System. The U.S.-led
financial rescue package has no effect on the internal financial situation in
Mexico. Any viable program to revive Mexico's economy must begin with a
complete repudiation of the key flaw in the economic policy of the previous
government, namely pegging the peso to the dollar. Experience teaches us that a pegged currency implies a future
devaluation. From the very outset,
Mexico's new government must publicly admit that in the future the Banco de Mexico will target internal
price stability rather than a fixed exchange rate as part of a new program for
stable economic growth and investment within the North American Free Trade
Agreement.
u Over
the long-term, Washington must eventually address the issue of foreign
debt. Treasury Secretary Rubin has told
members of Congress that U.S. loan guarantees are be backed by oil revenues. I suspect that certain members of Congress
are preparing to tell Mr. Rubin in very blunt terms that much (if not all) of
current Mexican oil exports are pledged as collateral on existing loans and
foreign debt. I myself am a director of
a Houston-based firm, Arriba Ltd., which
is a creditor of Pemex.
Moreover, since Pemex regularly pays in excess of 95 percent of its
gross annual revenues (including dollar funds generated by exports) to the
Mexican Treasury in the form of an energy extraction tax, Mr. Rubin's claims as
to the availability of collateral to secure the loan guarantees are clearly
incorrect. Were the Mexican government
deprived of the revenues of Pemex, it would be left in a financially untenable
position and would be forced to default on its foreign and domestic
obligations. [9]
Critics
of free market economic reforms in the developing world are already using
Mexico and will use Argentina's disintegration as examples of the
"failure" of free market policies.
The true blame for these unfortunate situations lies first and foremost
with the wide swings in U.S. interest rates from 1989 until today, and second
with the underlying political problems in each country, problems for which in
the case of Mexico the United States must share a large part of the blame. Putting aside the rosy propaganda generated
by the governments in Mexico City and Washington over the past 6 years, Mexico
remains a country ruled for the benefit of the few at the expense of the
many. Corporate statism and personal
corruption, not free markets and the rule of law, are the governing
principles.
During
the past 5 years, numerous errors of financial prudence and due diligence have
been committed in the emerging markets, both by banks and their clients. Yet the greatest mistake of all was made
when foreign investors sitting far away in Boston and New York actually
believed that the likes of Carlos
Salinas would treat them better than he treats his own people. Thank you.
#
[6] See
Osterberg, William P., "Capital Flows to Mexico," Economic Commentary, Cleveland Federal
Reserve Bank, December 1, 1994. He
writes: "It may not matter much that analysts have often ignored capital
flows [to Mexico], depending on how such flows have been used. Ideally, in the
case of an economy as dependent on international trade as is Mexico, capital
inflows would be largely channeled into investments to boost productivity and
to lower prices, thus improving the current account balance, national economic
output, and employment. There is only mixed evidence that this has occurred,
however. While the volume of capital goods imports has risen steadily since well
before the surge in capital flows, there has been no clear increase in the
share of imports accounted for by capital goods. The capital flows have also
apparently not led to increased domestic expenditure on capital goods, because
the share of gross fixed capital formation to GDP has not risen appreciably
since before the 1990 surge in capital flows. Thus, there is only weak evidence
that the capital inflows have been used mainly to invest in productivity
enhancement."
[9] For example, the Mexican government must make
payments on its external debt of roughly $5 billion in 1995, compared with net
dollar revenues from oil exports of about $6.5 billion ($7.4 billion in oil
exports, less imports of gasoline and
other refined energy products from the U.S.).
When the service of Pemex debt is also included in the calculations, it
becomes clear that on a cash-flow basis, there is no free dollar revenue available
to provide security on the U.S. loan guarantees for Mexico. Indeed, as Mexico's export revenues
gradually dwindle over the next 4-5 years, it is virtually inevitable that the
Mexican government will ask the U.S. for subsidies to support capital
investment in oil production and refining capacity. Privatization of Mexican oil is not simply desirable, but is in
fact inevitable.