Remarks by Christopher Whalen 1
Council on Foreign Relations
New York, N.Y.
March 6, 1995
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:
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.
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.
# 1 Mr. Whalen is chief financial officer of Legal Research International, a Washington-based firm that advises and represents investors regarding due diligence, payment and credit risk in international markets. He also publishes The Mexico Report, a fortnightly review of political and financial developments in Mexico. Telephone: (617) 747-0115, Electronic Mail: firstname.lastname@example.org.
2 See Whalen, Christopher, "Mexico's Government Creates Another Debt Crisis," Wall Street Journal, March 12, 1992.
3 I owe a debt of gratitude to Mr. Eduardo Valle for this concept.
4 Employment in the maquiladora sector reached 550,000 by the end of 1994, although these facilities are almost exclusively used for export and contribute little to the local economy. For example, with the in-bond sector, Mexican manufactured exports in the first 10 months of 1994 were $41.485 billion, but excluding the maquiladoras drops the figure down to $20 billion, including oil exports. See El Financiero, February 3, 1995, p. 28A.
5 See Whalen, Christopher, "Mexico: El Sistema Narco," Dinero of Bogota, Colombia, November 1994, pp. 162-176.
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."
7 Mexico's total foreign debt, public and private, will require over $20 in principal and interest payments in 1995. This figure does not include interest and principal payments on domestic, peso debt instruments held by foreigners. See also Whalen, Christopher, "South of the Bailout," The Washington Post, February 5, 1995.
8 For an excellent overview of the business and political dealings of Raul Salinas, see the November 21, 1994 issue of Proceso (No. 942), which devoted almost half of the issue to "El Hermano incomodo."
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.