Mexican Currency Crisis of 1995

The Mexican peso had been pegged to the dollar since the early 1980s when the International Monetary Fund had made it a condition for lending money to the Mexican government to help bail the country out of a 1982 financial crisis. Under the IMF-brokered arrangement, the peso had been allowed to trade within a tolerance band of plus or minus 3 percent against the dollar. The band was also permitted to "crawl" down daily, allowing for an annual peso depreciation of about 4 percent against the dollar. The IMF believed that the need to maintain the exchange rate within a fairly narrow trading band would force the Mexican government to adopt stringent financial policies to limit the growth in the money supply and contain inflation.

Until the early 1990s, it looked as if the IMF policy had worked. However, the strains were beginning to show by 1994. Since the mid-1980s, Mexican producer prices had risen 45 percent more than prices in the United States, and yet there had not been a corresponding adjustment in the exchange rate. By late 1994 , Mexico was running a $17 billion trade deficit, which amounted to some 6 percent of the country's gross domestic product and there had been an uncomfortably rapid expansion in the countries public and private-sector debt. Despite these strains, Mexican government officials had been stating publicly that they would support the peso's dollar peg at around $1 = 3.5 pesos by adopting appropriate monetary policies and by intervening in the currency markets if necessary. Encouraged by such public statements, $64 billion of foreign investment money poured into Mexico between 1990 and 1994 as corporations and mutual fund money managers sought to take advantage of the booming economy.

However, many currency traders concluded that the peso would have to be devalued, and they began to dump pesos on the foreign exchange market. The government tried to hold the line by buying pesos and selling dollars, but it lacked the foreign currency reserves required to halt the speculative tide (Mexico's foreign exchange reserves fell from $6 billion at the beginning of 1994 to under $3.5 billion at the end of the year). In mid-December 1994, the Mexican government abruptly announced a devaluation. Immediately, much of the short-term investment money that had flowed into Mexican stocks and bonds over the previous year reversed its course, as foreign investors bailed out of peso-denominated financial assets. This exacerbated the sell-off of the peso and contributed to the rapid 40 percent drop in its value.

The IMF stepped in again, this time arm in arm with the US government and the Bank for International Settlements. Together the three institutions pledged close to $50 billion to help Mexico stabilize the peso and to redeem $47 billion of public and private-sector debt that was set to mature in 1995. Of this amount, $20 billion came from the US government and another $18 billion came from the IMF (which made Mexico the largest recipient of IMF aid up until that point). Without the aid package, Mexico would probably have defaulted on its debt obligations, and the peso would have gone into free fall. As is normal in such cases, the IMF insisted on tight monetary policies and further cuts in public spending, both of which helped push the country into a deep recession. However, the recession was relatively short-lived, and by 1997 the country was once more on a growth path, had pared down its debt, and had paid back the $20 billion borrowed from the US government ahead of schedule.¹⁷ (The accompanying Management Focus details how this crisis affected the US automobile industry, which before the crisis, was experiencing booming sales in Mexico.)  Russian Ruble Crisis

The IMF's involvement in Russia came about as the result of a persistent decline in the value of the Russian ruble, which was the product of high inflation rates and growing public-sector debt. Between January 1992 and April 1995, the value of the ruble against the US dollar fell from $1=R125 to $1=R5130. This fall occurred while Russia was implementing an economic reform program designed to transform the country's crumbling centrally planned economy into a dynamic market economy. The reform program involved a number of steps, including the removal of price controls on January 1, 1992. Prices surged immediately and inflation was soon running at a monthly rate of about 30 percent. For the whole of 1992, the inflation rate in Russia was 3,000 percent. The annual rate for 1993 was approximately 900 percent.

Several factors contributed to Russia's high inflation. Prices had been held at artificially low levels by state planners during the Communist era. At the same time there was a shortage of many basic goods, so with nothing to spend their money on, many Russians simply hoarded rubles. After the liberalization of price controls, the country was suddenly awash in rubles chasing a still limited supply of goods. The result was to rapidly bid up prices. The inflationary fires that followed price liberalization were stoked by the Russian government itself. Unwilling to face the social consequences of the massive unemployment that would follow if many state-owned enterprises quickly were privatized, the government continued to subsidize the operations of many money-losing establishments. The result was a surge in the government's budget deficit. In the first quarter of 1992 the budget deficit amounted to 1.5 percent of the country's GDP. By the end of 1992 it had risen to 17 percent. Unable or unwilling to finance this deficit by raising taxes, the government found another solution--it printed money, which added fuel to the inflation fire.

With inflation rising, the ruble tumbled. By the end of 1992, the exchange rate was $1=R480. By the end of 1993 it was $1=R1,500. As 1994 progressed, it became increasingly evident that due to vigorous political opposition, the government would not be able to bring down its budget deficit as quickly as had been thought. By September the monthly inflation rate was accelerating. October started badly, with the ruble sliding more than 10 percent in value against the US dollar in the first ten days of the month. Then on October 11, the ruble plunged 21.5 percent against the dollar, reaching a value of $1=R3926 by the time the foreign exchange market closed!

Despite the announcement of a tough budget plan that placed tight controls on the money supply, the ruble continued to slide and by April 1995 the exchange rate stood at $1=R5120. However, by mid-1995 inflation was again on the way down. In June 1995 the monthly inflation rate was at a yearly low of 6.7 percent. Moreover, the ruble had recovered to stand at $1=R4559 by July 6. On that day the Russian government announced that it would intervene in the currency market to keep the ruble in a trading range of R4,3000 to R4,900 against the dollar. The Russian government felt that it was essential to maintain a relatively stable currency. They announced that the central bank would be able to draw upon $10 billion in foreign exchange reserves to defend the ruble against any speculative selling in Russia's relatively small foreign exchange market.

In the world of international finance, $10 billion is small change and it wasn't long before Russia found that its foreign exchange reserves were being depleted. It was at this point that the Russian government requested IMF loans. In February 1996, the IMF obliged with its second largest rescue effort after Mexico, a loan of $10 billion. In return for the loan, Russia agreed to limit the growth in its money supply, reduce public sector debt, increase government tax revenues, and peg the ruble to the dollar.

Initially the package seemed to have the desired effect. Inflation declined from nearly 50 percent in 1996 to about 15 percent in 1997; the exchange rate stayed within its predetermined band; and the balance of payments situation remained broadly favorable. And in 1997, the Russian economy grew for the first time since the breakup of the former Soviet Union, if only by a modest half of 1 percent of GDP. However, the public sector debt situation did not improve. The Russian government continued to spend more than it agreed to under IMF targets, while government tax revenues were much lower than projected. Low tax revenues were in part due to falling oil prices (the government collected tax on oil sales), in part due to the difficulties of collecting tax in an economy where so much economic activity was in the "underground economy," and partly due to a complex tax system that was peppered with loopholes. Currently available estimates indicate that in 1997, Russian federal government spending amounted to 18.3 percent of GDP, while revenues were only 10.8 percent of GDP, implying a deficit of 7.5 percent of GDP, which was financed by an expansion in public debt.

The IMF responded by suspending its scheduled payment to Russia in early 1998 pending reform of Russia's complex tax system, and a sustained attempt by the Russian government to cut public spending. This put further pressure on the Russian ruble, forcing the Russian central bank to raise interest rates on overnight loans to 150 percent. In June 1998, the US government indicated that it would support a new IMF bailout . The IMF was more circumspect, insisting instead that the Russian government push through a package of corporate tax increases and public spending cuts in order to balance the budget. The Russian government indicated that it would do so, and the IMF released a tranche of $640 million that had been suspended. The IMF followed this with an additional $11.2 billion loan designed to preserve the ruble's stability.

Almost as soon as the funding was announced, however, it began to unravel. The IMF loan required the Russian government to take concrete steps to raise personal tax rates, improve tax collections, and cut government spending. A bill containing the required legislative changes was sent to the Russian parliament, where it was emasculated by anti-government forces. The IMF responded by withholding $800 million of its first $5.6 billion tranche, undermining the credibility of its own program. The Russian stock market plummeted on the news, closing 6.5 percent down. Selling of rubles accelerated. The central bank began hemorrhaging foreign exchange reserves as it tried to maintain the value of the ruble. Foreign exchange reserves fell by $1.4 billion in the first week of August alone, to $17 billion, while interest rates surged again.

Against this background, on the weekend of August 15 - 16, top Russian officials huddled together to develop a response to the most recent crisis. Their options were severely limited. The patience of the IMF had been exhausted. Foreign currency reserves were being rapidly depleted. Social tensions in the country were running high. Moreover, the government faced upcoming redemptions on $18 billion of domestic bonds, with no idea of where the money would come from.

On Monday, August 17, prime minister Kiriyenko announced the results of the weekend's conclave. Russia, he said, would restructure the domestic debt market, unilaterally transforming short-term debt into long-term debt. In other words, the government had decided to default on its debt commitments. The government also announced a 90-day moratorium on the repayment of private foreign debt, and stated that it would allow the ruble to decline by 34 percent against the U.S. dollar. In short, Russia had in effect turned its back on the IMF plan.

The effect on Russia was immediate. Overnight, shops marked up the price of goods by 20 percent. As the ruble plummeted, currency exchange points were only prepared to sell dollars at a rate of 9 rubles per dollar, rather than the new official exchange rate of 6.43 rubles to the dollar. As for Russian government debt, it lost 85 percent of its value in a matter of hours, leaving foreign and Russian holders of debt alike suddenly gaping at a huge black hole in their financial assets.¹⁸