Working Paper
Causes and Lessons of the Mexican Peso Crisis

This paper analyses in depth the causes of the Mexican peso crisis, so as to learn relevant lessons for similar crisis occurring in other developing or transitional economies. The study follows a relatively chronological order, examining first the apparently golden period, when Mexico was acclaimed world-wide as a successful reformer. The next section analyses the period when 'clouds emerge and darken', examining policy options that could have been followed by the economic authorities. The last section focuses on the devaluation of 20 December 1994, and the resulting crisis. In the analysis of the causes of the grave Mexican peso crisis, consensus is emerging around some of them. These include the large scale of the current account deficit, as well as the fact that a large part of it was funded by relatively short-term capital inflows. They also include the fact that a somewhat overvalued exchange rate was welcomed by a government strongly committed to rapid inflation reduction. The causes include the fact that such a high proportion of government debt paper was so short-term, such a high proportion of it was in the hands of non-residents and that - during 1994 - the government allowed the transformation of a large part of it into dollar - denominated paper. This study concludes that two other sets of factors were also important, but have been either neglected or insufficiently emphasised in the literature. The first is that the process of liberalisation in Mexico, both of the financial sector and of the capital account, was perhaps too rapid and that too many changes were made simultaneously. Secondly, the severity of the Mexican peso crisis can partly be explained by imperfections in international capital markets, which can lead to huge over-reactions to relatively small changes in countries' economic fundamentals. The paper analyses, both from a theoretical and empirical perspective, the nature of imperfections in international capital markets.