-13-

exceeded the rate of inflation by a rather wide margin. While U.S. economic
activity is now expanding once again, and while nominal interest rates in world
markets have fallen from their peaks, real interest rates continue to be posi-
tive and appear likely to remain so for the foreseeable future, although not
necessarily at the current level. In this environment, borrowing is costly.
Nominal interest rates cover not only an inflation premium, but also a positive
real remuneration for the other risks involved and for the use of the funds.
Moreover, with the reduced rates of inflation now prevailing in the industrial
countries, it is no longer possible for debtor countries to contemplate the
possibility of making principal repayments in much cheaper dollars on the
assumption that the export prices for their products will coontinue to rise
rapidly.

In such a world, the damage that debtor countries might suffer from
pursuing ill-advised domestic policies is greater and more difficult to repair.
This makes it all the more important for them (a) to avoid such policies, and
(b) to recognize the need for prompt policy adjustments when world economic
circumstances change. The borrowing strategy of the 1970s is no longer appro-
priate.

The Mexican experience of the past few years illustrates vividly what
can happen when these conclusions are ignored. But the progress made in 1983
in rebuilding a viable Mexican economy shows that, with steadfastness and

determination, there may be a way to overcome the crisis.


-4-

market was closed. With remarkable speed, on the understanding that Mexico
would seek assistance from the International Monetary Fund, foreign banks
agreed to roll over public sector principal payments owed to them pending a
comprehensive debt restructuring and emergency official assistance to Mexico of
more than $4.5 billion was arranged.

However, once again, the Mexican government did not quickly adopt
measures to strengthen its stabilization effort, and instead, on September 1,
instituted comprehensive exchange controls and a fixed two-tiered exchange
rate system, while ‘lowering domestic interest rates. The nationalization of
banks, also announced on September 1, dealt a further blow to the confidence of
capital market participants in the policies and prospects of Mexico. Negotia-
tions with the International Monetary Fund dragged on, although in the end they
were successfully concluded in November.

The scarcity of foreign exchange, import and exchange restrictions,
and the. depreciation of the peso in real terms reduced the current-account
deficit in 1982 to less than a third of the record 1981 level, mainly because
of a 40 percent contraction in imports. But real GDP growth virtually ceased
and inflation climbed to three-digit levels. The scarcity of foreign exchange
after August 6 and the subsequent exchange controls also led to the widespread
accumulation of private arrears on debts to banks and to suppliers, although
even before August some private firms experiencing financial difficulties had
already fallen behind in their debt servicing.

Short-run Strategy to Resolve the Crisis

Stabilization measures intended to carry out the IMF-approved
program began to be implemented in December 1982, as soon as the new admini-
stration took office. They included an increase in the value-addecl tax and

cuts in public spending--in particular reductions in public investment expen-


-9-

increase in the availability of official financing, either on a multilateral or
a bilateral basis, it is likely to prove useful for Mexico to devise policies
that will attract private foreign equity capital and that will stimulate the
return of expatriated Mexican capital. This may require actions to minimize
the risk of loss through devaluation or expropriation, a comnitment to a vigor-
ous private sector, a stable and predictable set of investment rules, and a
reasonable degree of social peace.

The Responsibilities of the Creditors

The Mexican strategy outlined above has an important complement in
the strategy that should evolve in the creditor countries to help resolve not
only Mexico's liquidity crisis but also those of other countries experiencing
external debt difficulties. Since world events over which Mexico had no con-
trol played a part in bringing about the Mexican liquidity crisis, it is only
equitable to place some of the responsibility for resolving the crisis on the
creditors. As noted earlier, the creditors have already done much to deal with
the crisis in the short-run, but this is only a Seginning.

In the long run, resolution of the crisis requires an expanding
world economy that will absorb a growing volume of Mexican and other less
developed country products and services at remunerative prices. The
restoration of a steady and sustainable rate of real economic growth in the
industrial countries is, of course, in their own interest on other grounds, so
that one can rest assured that efforts to this end will be made. Conventional
wisdom suggests that an economic recovery and expansion is more likely to
extend over a long period if it proceeds at moderate rates that are sustainable
than if it achieves high rates that generate inflation and lead to restrictive
policies that interrupt it. However, cyclical fluctuations have not been

abolished, and Mexico and other less developed countries must be prepared for


-6-

On the fiscal side, public spending slowed sharply in the first half
of the year and, although public sector revenues were less than expected
(mainly because of the low rate of economic activity), the public sector defi-
cit was significantly lower. The reduced need for financing by the public
sector was reflected in slower money supply increases. On the external side,
the current account, which shifted into surplus in the third quarter of 1982 as
imports became increasingly depressed, has remained in surplus in the first
half of 1983 in spite of some recovery in imports and in spite of the reduced
earnings from oi] exports that the lowering of oi] prices in March brought
about. In part, this reflects the impact of the decline in world interest
rates after July 1982 and the effect of the peso depreciation on non-oil
exports and services.

On the other hand, economic activity remains depressed and it is
widely expected that real GDP in 1983 will be at least 4 percent lower than in
1982. While there are no statistics to prove this, it must be presumed that
unemployment has increased. This probably has contributed to the willingness
of organized labor to accept wage settlements this year that have been well
below the twelve-month rate of increase in prices. While wage restraint is an
important element in the adjustment strategy under way, there is no cenying the
fact that a reduction in real wages is painful and may be socially disruptive.
At the same time, if the monthly rate of price increases, which has shown a
tendency to ease somewhat in recent months, can be brought down significantly
further, the reduction in real wages may be minimized.

Long-run Strategy

The short-run strategy to resolve the Mexican liquidity crisis has

been based on (1) implementation of measures designed to adjust the Mexican

economy to the changed world economic circumstances, (2) ensuring the


-5-

ditures and increases in public sector prices so as to reduce subsidies--a
substantial increase in interest rates, and restraints on wage increases. In
addition, the peso was devalued a third time and some flexibility was restored
to the exchange rate system with a view to maintaining the country's inter-
national competitiveness. The program calls for a reduction of the public
sector daficit/GDP ratio, which exceeded 18 percent in 1982, to 8.5 percent in
1983 and for further reductions in 1984 and 1985.

Adoption of these policies enabled Mexico to obtain IMF financial
assistance ($3.9 billion to be disbursed over three years) and, with the
intervention of the IMF management, a $5 billion foreign bank loan (linked to
the IMF credit). Extraordinary export financing from Western governments
expected to total $2 billion in 1983 has also been arranged. In addition,
Mexico has restructured about $11.5 billion of public sector principal payments
owed to foreign banks and falling due between August 1982 and December 1984 ,1/
and about $1.5 billion in private sector debt owed to or guaranteed/insured by
official agencies in the creditor countries. A number of mechanisms to pay
private sector arrears on rescheduled terms have also been instituted.

The performance of the Mexican economy under these policies has been
both encouraging and discouraging. On the one hand, Mexico has remained in
compliance with the performance criteria specified in its agreement with the
IMF and has been able to continue to avail itself of the financing that is
conditioned on this compliance. As a result, it has repaid all of the emer-
gency assistance obtained from foreign monetary authorities in August 1982.
Performance has been especially encouraging on the fiscal side and on the
external payments side, to the extent that Mexico has been able to delay
drawings on the $5 billion bank loan well beyond their original availability
dates.

V he restructuring of another $8.5 billion is still under negotiation.


-8-

After the IMF agreement lapses at the end of 1985, assuming that
there will be no need to renew it, an important element in nurturing inter-
national financial market confidence will be to follow the guidelines of what
might be called a policy of reasonable borrowing./ One of these guidelines
is to use external borrowings, either directly or indirectly, only for produc-
tive purposes, not for consumption or to pay interest on previous debts or to
finance an outflow of capital, so as to generate the capacity to service the
additional debt. Another guideline is to maintain a realistic exchange rate so
as to prevent erosion of the country's international competitiveness, A third
one is to maintain interest rates high enough to act as a disincentive to an
outflow of domestic capital and as a magnet for foreign funds. A fourth one is
to minimize the use of price controls and subsidies since they tend to encour-
age overconsumption and to distort the allocation of productive resources,
thereby impairing the efficient functioning of the economy and hence its debt
servicing capacity. A fifth one is to follow appropriate domestic fiscal and
monetary policies and in particular to be willing to take fiscal and monetary
policy steps in a timely fashion to mitigate adverse world or domestic economic
and financial developments and to limit the current account deficit to a level
corresponding to the amount that can reasonably be expected to be available
from external sources of financing. Adherence to the first, second, and fourth
guidelines will also contribute importantly to the strengthening of the export
sector.

Beyond this, since the banks cannot be expected to provide all of
the financing that Mexico may need if it is to resume a satisfactory rate of
real GDP growth, and since the climate does not seem favorable for a large
T7-See my paper "How to Borrowing Reasonably", in Foreign Debt_and Latin

red

American Economic Development, (Antonio Jorge, Jorge Salazar 0, and
Rene P. Higonnet, editors), Pergamon Press, New York, 1983, pp. 77-84.



International Finance Discussion Papers
Number 228

September 1983

A STRATEGY TO RESOLVE MEXICO'S LIQUIDITY CRISIS
by

Yves Maroni

NOTE: International Finance Discussion Papers are preliminary materials
circulated to stimulate discussion and critical comment. References in
publications to International Finance Discussion Papers (other than an
acknowledgment by a writer that he has had access to unpublished material)
should be cleared with the author or authors.


-le

immense benefits to these countries. Since approximately $60 billion of
Mexico's external debt is subject to floating interest rates, the savings
associeted with each percentage point decline in interest rates would amount to
$600 million per year.

An appropriate strategy for the creditor countries should include
the avoidance of excessively restrictive bank regulatory measures which, while
designed to promote the soundness of banks, will prevent a resumption of bank
lending to the less developed countries on a voluntary basis. There is little
doubt that many banks failed to exercise proper caution in extending loans to
them iri recent years and that some strengthening of the regulatory process and
the enactment of some lending restraints are inevitable. However, if the
result should be to discourage banks from making new loans to the less
developed countries, it would make the task facing such countries as Mexico
considerably more difficult. In the absence of a revival of voluntary bank
lending, Mexico and other less developed countries would have to place greater
reliance on other sources of capital and, failing this, would be forced to
choose between making greater sacrifices or seeking ways to reduce their
scheduled interest payments. The former would imply lower imports by them, the
counterpart of which would be a loss of jobs in the supplying countries--and
when it comes to supplying Mexico, this means chiefly the United States--
whereas the latter would have incalculable consequences for the soundness of
the banking system that the new regulatory measures were meant to enhance.
Clearly, the effort to tighten the regulations governing foreign lending by
U.S. banks is an exercise in tight-rope walking. If pushed too far, it has the
potential of doing in its own way what the Smoot-Hawley tariff of 1930 did to
world trade and, through it, to the economic and even the political fabric of

the world in the 1930s.


- 10 -

the next economic downturn which must surely come, even if its timing cannot be
predicted. They should build up international reserves to provide a cushion
that will given them time, after the downturn begins, to readjust their
policies to the changed economic circumstances.

The industrial world must also be ready and willing to absorb an
increase in imports from Mexico and other less developed countries. This
implies that they will avoid an intensification of protectionist measures or,
better still, that they will reduce trade barriers that impede imports from
these countries. The world should remember the lesson of the 1930s when
sharply increased tariffs and the use of quantitative restrictions made it
impossible for indebted countries to earn through exports the means with which
to pay their debts. It goes without saying that industrial country acceptance
of increased imports from the less developed countries does not and should not
amount to a license for the latter to engage in unfair competitive practices
such as selling for export at lower prices than in the home market, or pro-
viding special subsidies or tax rebates for exporters. An export subsidy code
has been developed within the GATT and they should adhere to such a code if
they hope to find acceptance for their products in the industrial countries.

The United States has a further contribution to make, not only to
the resolution of the debt difficulties of the less developed countries, but
also to its own economic and financial future and that of the other industrial
countries. If it will pursue policies that will substantially reduce its own
fiscal deficit in coming years, this will considerably brighten the prospects
that world interest rates will not rise significantly as the economic expansion
proceeds, and there may even be a possibility that world interest rates might
decline somewhat. Given the magnitude of the Mexican external debt -- indeed,

the external debt of many of the less developed countries--this could yield


-7-

continued availability of external financing during the adjustment period,
especially from banks, and (3) alleviating through debt restructuring the
crush‘ing burden of a heavy concentration of maturities falling due. Two
important elements in this strategy have been the adoption of an IMF-approved
stabilization program and the decision to continue paying promptly all interest
due on the external public debt and to settle as soon as possible the arrears
that accumulated before December 1982 on the interest payments on private
sector debts. Lacking these steps, it would have been impossible to secure the
agreement of the banks (a) to the rollover of principal payments that has now
lasted more than a year, (b) to the increase in their exposure to Mexico repre-
sented by the $5 billion loan of last March, and (c) to the public sector debt
restructuring that is now nearing completion.

For the balance of the adjustment period and in the long run, it
will be essential to strengthen the export sector and to bring about a revival
of the volunatry flow of capital into Mexico. This is desirable not only to
help resolve the liquidity crisis but also to provide the means of financing a
recovery of imports and to help achieve a sustainable rate of real economic
growth and the benefits of expanding trade. To revive the voluntary capital
inflow, Mexico should aim to restore the confidence of foreign banks and other
capital market participants in the policies and prospects of the country. This
requires continued prompt payment of all interest falling due and the resump-
tion of debt servicing by private Mexican debtors whose debt payments are over-
due, either under debt restructuring agreements concluded with their private
foreign creditors pursuant to one of the “FICORCA" plans or under any other
mutually agreed arrangement. It also requires continued compliance with the

performance criteria specified in the Mexican agreement with the IMF.


~-3-

oil exports, and indeed, in 1981, had succeeded in covering its $14 billion
current account deficit and the large captial outflow while adding to its
reserves. But much of the 1981 borrowings were short-term, creating a heavy
concentration of maturities in 1982. At the same time, a further increase in
the current-account deficit was being forecast for 1982. Market realization of
the magnitude of Mexico's 1982 external borrowing needs brought about a
hardening of terms on syndicated loans, including higher spreads and shorter
maturities. In May, the Mexican authorities negotiated a $2.5 billion credit
from a syndicate of banks, but the lead managers were able to sell only about
$350 million in participations to "second-tier" banks during the syndication
period, in spite of two extensions, and the lead banks found themselves having
to hold larger portions of this credit tnan they had planned. The poor
reception of this credit forced postponement of other Mexican borrowings that
had been under preparation and led to a growing reluctance of lenders to roll
over maturing short-term credits. When sharp increases in the regulated prices
of gasoline, electricity, tortillas and bread were announced on August 1, the
public recalculated the prospective rate of inflation and concluded that
another devaluation was inevitable. This caused a renewed outflow of capital,
and, with reserves running low and access to external borrowings severely cur-
tailed, the Bank of Mexico was forced once again to withdraw support of the
peso.

The Crisis and Its Aftermath

On August 6, a dual exchange rate system was instituted. This
raised fears of full-fledged exchange controls and triggered a large scale
conversion of foreing-currency accounts at Mexican banks into foreign exchange.
On August 13, these conversions were banned, the foreign-currency accounts at

Mexican banks were ordered converted into pesos, and the foreign exchange


-2-

account deficit from $2 billion in 1977 to almost $8 billion in 1980, in spite
of a rise in oil export earnings from $1 billion in 1977 to $10 billion in
1980. ,

In 1981, weakness in the world oi] market exacerbated by a miscalcu-
lation in Mexico's oil pricing policy in June and July, a recession in the
industrial countries, and an accelerated rise in interest payments on the
growing external debt as world interest rates reached new highs, worsened the
situation still further and the current-account deficit rose to $14 billion,
more than 45 percent of total current-account earnings. Fears of a large peso
devaluation and an outflow of capital developed in 198] as awareness of the
growing current-account deficit increased and as it became clear that only
nominal reductions in public spending were being made in the face of the lower
public revenues that the decline in world oil prices was bringing about. The
fears and the capital outflow intensified as the realization spread that
expansionary domestic policies would continue in 1982--an election year--and
that the short-term outlook for exports was not encouraging. In Feoruary 1982,
the Mexican authorities concluded that it would be too costly to continue
supporting the exchange rate, and allowed the peso to depreciate by about 40
percent.

The Mexican government did not quickly adopt a meaningful stabili-
zation program after the devaluation and instead took steps to alleviate its
impact, including large wage increases and business tax concessions and
benefits. On April 20, 1982, a stabilization plan was announced. But the
Presidential election, only ten weeks away, constrained the capacity of the
Mexican government to implement the plan forcefully.

Mexico had been able to borrow large sums on external financial

markets since 1977, mainly on the strength of the potential expansion of its


A Strategy to Resolve
Mexico's Liquidity Crisis
by
Yves Maroni*

A discussion of the strategy to resolve Mexico's liquidity crisis
must start with an analysis of the origins of the crisis and a review of its
principal phases. An understanding of what went wrong and of the emergency
actions that followed and that are now history will shed valuable light on the
problem and provide useful insight for the formulation of an appropriate
strategy for the coming years.

The Origins of the Crisis

Mexico's financial crisis, which burst in full bloom in August 1982,
had been brewing for nearly four years. It had its origins in the policies
implemented by the Mexican authorities since 1978 and developments in the
world economy following the second oi] shock. It became inevitable when the
Mexican authorities did not act forcefully to adjust these policies to the
changed world economic circumstances.

Mexico's expansionary policies implemented since 1978 to promote
employment yielded a real growth rate averaging over 8 percent in 1978-81 and
lower unemployment, but these successes were achieved at the price of large
public sector deficits, accelerating inflation, and rapid import growth. In
spite of a persistent and growing differential between Mexican and U.S. infla-
tion, the peso/dollar exchange rate was held virtually stable in 1978-80 and
was allowed to depreciate only slowly in 1981. The result was a decline in
Mexico's international competitiveness which further stimulated imports and

held down non-oil exports, and contributed to a near quadrupling of the current

*Paper presented at a conference on United States-Mexico trade and financial
interdependence, Stanford University, September 15-17, 1983. This paper
represents the views of the author and should not be interpreted as reflecting
the views of the Board of Governors of the Federal Reserve System or other
members of its staff.


-12-

Finally, the banks in the creditor countries should recognize that
the maturity profile of Mexico's external debt still involves heavy concen-
trations of maturities in some of the years before the end of this decade.

This suggests that they should structure new loans to Mexico in such a way as
to minimize the repayments due in these years. Even if they do, they may be
asked, in due course, to consider additional debt restructuring in the years of
heavy concentration of maturities. There is plenty of time to think about
this, but it is not too early for the banks to begin incorporating this
possibility in their forward planning, so that no one will be surprised if and
when it materializes.

Concluding Comments

The world of the 1980s is very different from that of the 1970s.
Then, the industrial countries, and particularly the United States, placed more
emphasis on maintaining output and employment and less emphasis on curbing
inflation. Interest rates prevailing in world markets, and especially in the
United States, were generally lower than the rate of inflation, and debtors
were encouraged to borrow more, not only because real interest rates were
negative, but also because principal repayments could be made in cheaper
dollars--i.e., dollars that could be earned with a declining volume of exports,
as export prices for the products of the debtor countries rose in dollar terms.

In such a world, the damage that debtor countries might suffer from
having pursued ill-advised domestic policies could be overcome with relative
ease with the help of the ongoing world inflation. ‘

But in the 1980s, the industrial countries, and particularly the
United States, have placed primary emphasis on the curbing of inflation and
have accepted a sharp and prolonged recession. Interest rates in these coun-

tries were allowed to rise to unprecedented nominal levels that have generally