Mexican Crisis Essay

1. Introduction

On 20th December 1994 Mexico devalued its peso by 15% against the US dollar in a bid to protect its rapidly depleting foreign reserves. But the attempt exacerbated the investor panic leading to further deterioration of the foreign reserves. Two days later Banco De Mexico was forced to float the peso and to abandon the fixed-peg exchange rate system.

Up till then Mexico was hailed as a “Star Student of IMF” for successfully transforming itself from a closed-economy to an open-economy by implementing market liberalization reforms; which included among other things, capital account liberalization, banking-sector liberalization and trade liberalization. Thanks to the reforms the Mexican economy was leaving behind the “lost decade”

Among the above factors the unsustainable external position or more precisely the unsustainable current account deficit received much attention during 1990’s as the 1997 East Asian crisis was also preceded by large current account deficits of respective countries. The same topic has again come into the spotlight with the widening current account deficit of US.

Hence the aim of this paper is to discuss the concept of sustainability of the current account deficit and to employ two major approaches to ascertain the sustainability of the current account deficit of Mexico during the crisis period. Finally it tries to identify the relative strengths and weaknesses of each

However, permanent or persistent deficits can have serious effects. First, they might increase domestic interest rates to attract foreign capital, and second, the accumulation of external debt due to persistent deficits will imply increasing interest payments, imposing an excess burden to future generations. As demonstrated in the Mexican 1994 crisis a large current account deficit may trigger a sharp hike in interest rates, a rapid depreciation of exchange rates and hence may disrupt the performance of the domestic economy. (Camarero et al, 2010), (Zubaidi et al,