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Mexico: What's Next?

Remarks by Christopher Whalen 1
Council on Foreign Relations
New York, N.Y.
March 6, 1995

This morning I will give you my assessment of the political and economic situation in Mexico. I first propose to briefly review the important developments of the past year and look at the current situation facing the government of President Ernesto Zedillo, then make some general predictions about the financial and social developments that we will see in Mexico in 1995 and beyond.

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:

1. The productive economy, excluding the small in-bond or maquiladora sector, has shrunk in terms of the total number of jobs and private sector companies.4 Dislocation in rural areas of Mexico has been massive, resulting in literally millions of impoverished people being driven from the land and into already crowded Mexican cities, a rising flow of desperate people who must eventually move north. High real interest rates and confiscatory taxation have made it impossible to support most types of productive business activity. Like Venezuela, defaults on business and consumer loans are rising very rapidly and the austerity measures being implemented by the Zedillo government at the behest of foreign creditors will only exacerbate credit quality concerns. On an aggregate basis, the Mexican banking system is clearly insolvent and cannot survive in its present form. It is very likely that many if not most of the recently privatized Mexican commercial banks will require government assistance before year-end.
2. The speculative economy, fueled by inflows of cheap dollars, inflated to vast size between 1990 and 1994. Now this process is moving in reverse as the collapsing prices for stocks, bonds and the peso destroy billions of dollars in wealth and reduce consumer purchasing power. By shifting the dollar borrowing necessary to finance imports -- and thus political stability -- from the public to private sector since 1989, Salinas and his cronies in the previous government cleverly made Mexico's economy seem larger through new dollar inflows, while leaving the ultimate liability with the private sector. The economic policies of Carlos Salinas emphasized raising billions of dollars in new foreign debt rather than boosting exports and job growth. The result is an economy that has more debt and arguably less ability to generate dollar income than it did in 1989. Once again, as in 1982, Mexico is in trouble because of excessive offshore borrowing and spendthrift economic policies, not because of a short-term liquidity problem, as the Clinton Administration suggests.
3. Finally we come to the criminal economy, by far the largest of the three sectors, which is built around narcotics trafficking, arms smuggling, kidnapping and other forms of illegal activity. The criminal economy has mushroomed in size and now clearly dominates the entire political landscape. Today, the $20-25 billion in profits from the $100 plus billion-per-year narcotics trade is twice the total revenues of the Mexican oil sector. Drugs are not simply a threat to the authority of the Mexican government, as even U.S. officials now grudgingly admit. Rather, as in the case of Colombia and Venezuela, narcotics has come to permeate all aspects of Mexican official and even private life. It is frequently impossible to do business or even live in many parts of the country without making a compromiso with the warlords who govern the narco system.5 My friends and colleagues in the political opposition, both on the left and the right, report that the drug lords and their allies in the government apparatus are now the ascendant political force in border states like Baja Norte, Sonora, and Cuahuila, and in many other parts of the country.

In purely financial terms, the Mexican meltdown signals the end of the latest cycle of offshore investment in Latin America, a reversal of falling monetary tides between 1989 and 1994. But the financial collapse of the past two months has as much to do with changes in U.S. interest rate policy as with the peculiar relationship between Washington and the nations south of El Paso. The real blame for the Tequila Effect and the extraordinary accumulation of new debt by Mexico -- which totaled some $160 billion in offshore obligations as of year-end 1994 -- largely belongs with Washington.

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.

What Next?

Let me close my remarks with a few thoughts about what we may or may not see in Mexico during the rest of this year:

• Politically speaking, the situation facing the government of Ernesto Zedillo is complex and very dangerous, including a threat to the personal safety of Zedillo himself. I want to applaud and encourage the steps taken by President Zedillo to deal with Mexico's financial crisis and, most recently, by arresting Raul Salinas de Gortari, the older brother of former President Salinas.8 Zedillo is currently involved in a desperate internal struggle with the forces of reaction in Mexico, including Salinas, former Agriculture Minister Carlos Hank Gonzalez, and other dinosaurios in the PRI old guard -- the same people who are suspected of engineering the murder of Luis Donaldo Colosio almost a year ago. So long as the case against Raul Salinas is confined to the murders of Jose Ruiz Massieu and Colosio, then the move by Zedillo will be a political affair to determine how independent Zedillo will be of reactionary elements led by Carlos Hank and Carlos Salinas. If the investigation begins to examine the vast corruption of which Raulito was the chief nexus on behalf of his brother and his father, Raul Salinas Lozano, then Zedillo will be declaring civil war on many powerful warlords who have the capacity to directly threaten Zedillo and members of the government loyal to him.
• In terms of the larger tactical situation facing the PRI around the country, the ruling party has suffered a grievous political blow due to the peso devaluation. The precipitous drop of the peso has hurt the possibilities for the ruling party in future state and local elections, even though public support for Zedillo himself has risen since the arrest of Raul Salinas. The recent election victory by the conservative PAN or Accion Nacional in the important central state of Jalisco came about for three reasons: (1) public anger over the 1993 assassination of Cardinal Juan Posadas, (2) the political disarray and corruption of the PRI inside the drug ravaged Pacific coast state, and (3) general public dismay over the collapse of the implicit pacto between the government and the electorate. In a very real sense, the people of Mexico cast their votes for Ernesto Zedillo in August of 1994 thinking that they were buying political and financial stability from the PRI. Now it is shown that the very ill effects of devaluation and political conflict that were attributed to a possible opposition victory have, in fact, come about under the PRI.
• Financially, Mexico faces the inevitability of private debt defaults during 1995 and the very real possibility of a public sector debt default, particularly if the U.S. government goes through with its threat to seize the country's oil revenues if a default occurs on the $20 billion loan facility provided by the Treasury and Federal Reserve System. The U.S.-led financial rescue package has no effect on the internal financial situation in Mexico. Any viable program to revive Mexico's economy must begin with a complete repudiation of the key flaw in the economic policy of the previous government, namely pegging the peso to the dollar. Experience teaches us that a pegged currency implies a future devaluation. From the very outset, Mexico's new government must publicly admit that in the future the Banco de Mexico will target internal price stability rather than a fixed exchange rate as part of a new program for stable economic growth and investment within the North American Free Trade Agreement.
• Over the long-term, Washington must eventually address the issue of foreign debt. Treasury Secretary Rubin has told members of Congress that U.S. loan guarantees are be backed by oil revenues. I suspect that certain members of Congress are preparing to tell Mr. Rubin in very blunt terms that much (if not all) of current Mexican oil exports are pledged as collateral on existing loans and foreign debt. I myself am a director of a Houston-based firm, Arriba Ltd., which is a creditor of Pemex. Moreover, since Pemex regularly pays in excess of 95 percent of its gross annual revenues (including dollar funds generated by exports) to the Mexican Treasury in the form of an energy extraction tax, Mr. Rubin's claims as to the availability of collateral to secure the loan guarantees are clearly incorrect. Were the Mexican government deprived of the revenues of Pemex, it would be left in a financially untenable position and would be forced to default on its foreign and domestic obligations. 9

Critics of free market economic reforms in the developing world are already using Mexico and will use Argentina's disintegration as examples of the "failure" of free market policies. The true blame for these unfortunate situations lies first and foremost with the wide swings in U.S. interest rates from 1989 until today, and second with the underlying political problems in each country, problems for which in the case of Mexico the United States must share a large part of the blame. Putting aside the rosy propaganda generated by the governments in Mexico City and Washington over the past 6 years, Mexico remains a country ruled for the benefit of the few at the expense of the many. Corporate statism and personal corruption, not free markets and the rule of law, are the governing principles.

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. Electronic Mail: rcwhalen@worldnet.att.net

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.

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