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520 June 30, 1986 A US, STRATEGY TO SOLVE MEXICO'S DEBT CRISIS INTRODUCTION Mexico's irternational debt problems are once again making Wall Street nervous. The roots of the current crisis-go.back at least a decade, but the problem first reached a critical stage in 'August 1982 when Mexico was unable to meet interest payments on its then $80 billion.debt. In response, th e country's creditors rescheduled Mexico's loans and devised a plan to reduce Mexico's crushing debt burden. This included an austerity strategy imposed by the International Monetary Fund (IMF). Despite these efforts (or because of them) Mexico's external debt now has mushroomed to over 98 billion and the country again faces possible default when $1.8 billion in interest payments fall due on June 30.
In contrast to the IMF's reflexive prescription of austerity, the Reagan Administration correctly urges that only economic growth pulls developing nations out of the debt quagmire and puts them on the road to prosperity. Translating this sound counsel int o policy, Treasury Secretary James Baker has made his proposed $20 billion in new private loans and $9 billion in new international organizations loans to debtor countries contingent on those nations adopting market-oriented economic reforms. In the contex t of the Baker Plan, Reagan Administration officials are working with their Mexican'counterparts IMF and World Bank officials, and private bankers on Mexico's crisis 1. For an overview of the debt crisis, see Esther Hannon and Edward L. Hudgins, "A US. Str ategy for Latin America's Debts Heritage Foundation Backarounder No. 502, April 7, 1986.
No doubt they will fashion.some short-term arrangement to help Mexico through the difficult months ahead more than mere words, the Reagan Administration must develop a growth-oriented economic plan for Mexico-otherwise an even greater Mexican crisis will explode in the future But if the Baker Plan is to be Mexico's current problems are a culmination of structural deficiencies in its internal economic policies and the r e sult of recent economic and political shocks. The most immediate factor is the 50 percent drop in oil prices since late last year sharply revenues from Mexican oil exports, which are critical to the country's foreign exchange earnings, thus making it very difficult for Mexico to meet its debt obligations underlying factors stem from Mexico's huge public sector, from massive state intervention into the economy, and from restrictive trade and investment policies. Admittedly, there have been signs of positive change in recent years. Budget cuts, for example, have been made.
Plans exist to sell to the private sector or close various money-losing state industries. Some investment rules have been relaxed. Freer trade is at least being considered. And special fact ories near the U..S. border, called maailadoras, governed by special trade and investment laws, are prospering. But these changes have been too small as yet to overcome Mexico's economic woes.
IMF austerity plan under which Mexico has operated for over th ree years has squeezed hard currency out of the.country for debt payments yet failed to promote economic growth. Learning from this experience the Reagan Administration should support a new IMF strategy for Mexico only if it promotes economic growth rathe r than economic contraction.
The Administration should not be overly concerned about losses suffered by Mexico's creditor banks, for the U.S. banking system is not currently in danger of collapse. The banks are capable of dealing with the debt situation on their own, relying on sound business principles instead of government help This has cut Although the oil price change has provoked the crisis, the International help, meanwhile, has been a mixed blessing. The A sound U.S. strategy for the Mexican debt cr i sis should be rooted in the Baker Plan. It could encourage, for example, a technique for reducing state holdings in the economy: foreign or Mexican.private businesses purchase Mexican debt from ban.ks and forgive the debt in exchange for Mexican governmen t-owned equity in Mexican businesses.
The Administration also could encourage Mexico to accelerate market-oriented reforms and structural economic adjustment. Among these are reducing the size of the public sector, deregulating the economy, and cutting tax es. And the U.S. could seek expansion of the macruiladora factory system and offer to cooperate in the establishment of complete free trade and investment zones 2The Mexican people want and deserve the opportunity to work and to prosper needs. Yet the cur r ent crisis offers Mexico the chance to change directions, to follow the kind of growth-oriented policies that have helped many of the developing countries of the Pacific Rim and are capturing the imaginations of many others. Only a free market strategy wi l l create new, productive jobs, improve Mexican business and labor efficiency, and spur real, non-inflationary economic growth to prosper and to meet its debt obligations But past statist policies have failed to meet these Only an economically.dynamic and g rowing Mexico will be able THE CURRENT DILEMMA Of Mexico's $98 billion foreign debt, nearly $75 billion is owed to commercial banks, with U.S. banks holding about one-third of the IOUs. The rest is owed to other banks worldwide. In the past, Mexico has ke p t up its interest payments and has been considered the ''good pupil'l among the debtor nations. This year Mexico will.owe approximately-$9.2 billion in interest payments, with $1.8 billion due on June 30 last year's $10.1 billion, thanks to lower interest rates, the 50 percent drop in oil prices has slashed Mexico's export oil earnings from $14.7 billion in 1985 to about around $7 billion this year.
Mexico thus faces a 25 percent real decline in government revenues While this year's total debt service amou nt is down from Mexico is seeking between $6 billion and $8 billion in new loans and concessions (for example, on interest rate spreads But the Reagan Administration maintains that most of this shortfall can be made up by Mexican cash on hand plus additio nal Mexican budget cuts.
Indeed, Mexico's cash balances are believed to total perhaps around $6 billion. Nonetheless, Mexico is seeking $2.5 billion in new foreign commercial bank loans, $1 billion each from the IMF and World Bank and about $600 million fr om the Paris Club, an informal group of government creditors. At this point, direct U.S. aid is not anticipated AMERICA 1 S ECONOMIC INTEREST IN MEXICO Mexico's economic difficulties pose a real, though limited threat to the U.S. economy partner, selling the U.S. mainly oil, machinery, and transportation equipment Mexico is America's third largest trading To accumulate currency to pay its debts, Mexico has been I 3reducing purchases of U.S. goods from $17.8 billion in 1981 to only $9 billion in 19
83. And while sales were back up to $13.6 billion by 1985, they are likely to decline again this year American saies to Mfxico dropped Manufacturers of U.S. machinery and transport equipment have been badly hit, with sales dropping from $8.7 billion in 1982 to $3 .7 billion in 19
83. Sales from this sector recovered only up to $6.6 billion in 1985 U.S. farmers, struggling with their own debt problems, also have suffered heavily. The initial'crisis in 1982 cut U.S. agricultural sales to Mexico from $1.9 billion to o nly $680 million: And.by 1985 sales were still only $920 million. Clearly, an economically strong and prosperous Mexico is better able to purchase U.S. goods and create American jobs. A stagnant Mexico purchases little and adds to America's export problem s U.S. SECURITY INTEREST IN MEXICO The economic crisis in Mexico is creating serious social and political problems t$at could trigger unrest, posing a security problem for.the U.S The economic crisis in Mexico is creating serious social and political probl e ms t$at could trigger unrest, posing a security problem for.the U.S Mexico's economy will contract this year for the third time in the last five years have increased unemployment, while real wages for those employed have dropped and the standard of living has slipped back to the 1967 1:evel. Most hard currency goes to debt payments, with little left over for productive investments. Businesses with .foreign currency have been placing it in bank accounts abroad, rather than investing in factories at home. To staunch the flight of capital, the state-owned banking system halted nearly all new credit to Mexican businesses.
This, of course,'cut investment further. Inflation also has been a chronic problem. And prices for basic food products have in some cases qua drupled endemic and on the rise The debt crisis and the IMF austerity measures Malnutrition and health problems among the poor are Mexicans are frustrated that there seems to be no end in sight to the economic hardship. For the first time since the 1910 r e volution which estab1ished:the current system of government, the legitimacy of 2. Trade figures in this section are from Latin Amer ican Trade Re view 1985: A U.S PersDectivg (Washington, D.C U.S. Department of Commerce, International Trade Administration 3. For an overview of these problems, see Mary Williams Walsh and S. Karene Witcher As Debt Turmoil Ebbs and Flows in Mexico, Human Misery Persists The Wa I1 Street Jou rnal June 12, 1986 4the government is being seriously questioned election fraud undert a ken by the ruling Institutional Revolutionary Party (PRI) against the opposition conservative National Action Party PAN) have -inte-nsified political divisions. Even more serious perhaps, are growing divisions within the PRI itself. The PRI normally gover n s by a consensus of'the var'ious interest groups including organized labor, party intellectuals, and government bureaucrats. Now these elements, nearly all more leftist than Mexican President Miguel de la Madrid, openly criticize the government and call f or more radical socialist approaches to Mexicols economic problems.
While the political stability of Mexico is not yet at stake further economic decline could unleash violent social unrest. This Charges of widespread would only benefit the left friendly to Cuba and the Soviet Union, driving millions of refugees A radical leftist regime in Mexico north, would pose one of this centuryis most serious national security problems for the U.S. Further, Mexico is one of America's most important sources of oil impo rts A disruption of the oil flow because of social unrest or a hostile government would.also pose a serious security threat.
MEXICO'S PAST ECONOMIC ERRORS While falling oil prices precipitated the latest crisis, Mexicols economic problems are rooted in its economic system, which relies heavily on socialist and statist economic policies. To take just one barometer of the problem: the government copsumed about 26 percent of Mexico's GNP in 1970; now it is 50 percent. Because the political power of the ruling PRI rests to a great extent on its ability to provide public sector jobs to supporters, public sector employment has increased throughout the debt crisis. The industries and enterprises owned by the state, meanwhile, have jumped from 86 in 1970 to over 1, 000 today. And trade barriers designed to keep out foreign goods to encourage domestic manufacture have only wasted capital and labor and made the Mexican economy less competitive.
Foreign investment and direct foreign ownershi p of Mexican businesses might have been expected to provide an infusion of capital and know-how, but such investments have been restricted sharply by the government. the capital for industry--which the government did by borrowing abroad. The result: Mexic o 's massive foreign debt. The sudden This has meant that the government had to raise much of 4. Luis Pazos, "The False Austerity Policies of the Mexican Government," Journal of Economic Growth, Vol. 1, No. 1, First Quarter, 1986 (Washington, D.C.: National Chamber Foundation 5 nationalization of the banks in 1982 by President de la Madrid's erratic predecessor, moreover, contributed to capital flight by demonstrating that the Mexican government could not be trusted to respect, much less to protect, the righ ts of private property.
Artificial attempts to stimulate economic growth last year by printing new paper money only accelerated the rise in inflation and the drop in the peso to about 750 per dollar from 250 per dollar last July.
RECENT ECONOMIC PROGRESS A number of Mexican statesmen realize that fundamental economic reform is sorely needed taken. Example: a number of state enterprises, such as Mexicha.
Airlines, are to be sold off to the private sector shut down, including recently an unprofitable steel mill in Monterrey Small but important first steps have been Others have been Tg ease part of its debt burden, Mexico is allowing debt-equity swaps foreign companies which, in turn, can exchange the debts for government-owned equity in both public and priv ate Mexican companies.
At least three such swaps, worth $81 million, already have taken place. This is an important development. Foreign businesses that own shares in Mexican companies have strong incentives to see that such companies succeed economically. They are likely to invest more capital and resources to protect their interests and to oppose international action that would constrain the Mexican economy Foreign banks sell portions of their Mexican debts to other Helpful also will be Mexico's imminent membership in the General Agreement on Tariffs and Trade (GATT the multilateral agreement that governs most world trade. This could lead to trade liberalization and stepped-up foreign investment. Some restrictions on direct foreign investments, in fact, h ave already been eased. Though foreign companies normally can own no more than 49 percent of a business in Mexico, for example, a 100 percent IBM-owned and operated facility was recently approved by the Mexican government.
One market-oriented policy developed over the last decafe known as the mauuiladora factory system, has been very s~~~essful.
Under this system U.S. companies have established over 700 plants in the northern border regions of Mexico without the usual requirement of 5. See testimony by Ass istant Secretary of the U.S. Treasury David C. Mulford before the Subcommittee on Western Hemisphere Affairs, Senate Foreign Relations Committee, June 10 1986 6. See Aaron Freiwald Mexico A Multinational Haven," Multinational Monitor, November 15, 1985 6h a ving Mexican partners U.S. the capital goods and semi-finished products necessary for production without the need to pay Mexican duties these plants'can be re-exported to the U.S. with tariffs being paid only on the value added to the goods take advantage of less expensive Mexican labor. These mamiladoras near Mexico's border with the U.S. are among the few bright spots on a dark Mexican economic landscape These plants are allowed to import from the Goods produced in This allows U.S. companies to Some crit i cs may charge that Mexico's economic reforms are too There is strong little, too late, or mere token gestures to appease foreign creditors. It is true that these reforms will not restructure Mexico's economy overnight--nothing could do that leftist opposi tion to such.reforms. Thus Mexican leaders must fight tough political battles for even small steps.
THE ROLE OF THE IMF For the past three years, Mexico has been complying with stiff conditions established by the IMF in exchange for financtal assistance. B ut IMF requirements are a two-edged sword. They are meant to generate sufficient hard currency for a country to keep up its debt payments. But while doing so, they may lead to long-term economic distress. For example, while it is economically sound to sla sh a country's budget deficit through spending cuts, it is economically dangerous to do it by raising taxes encourages tax hikes to cut budget deficits.
Yet the IMF often IMF conditions usually require increasing exports-and cutting imports. But this often deprives businesses of necessary capital goods obtained only from abroad. And inefficient local industries often must make up for lost imported goods which could have been purchased far cheaper than the local industry's production costs.
Developing countries, moreover, usually need to impqrt such resources as money and goods to grow serious long-term economic damage.
Closing markets to imports thus causes Thanks to such IMF conditions, theref.ore, Mexico is in many ways worse off as a result of internati onal "help." IMF requirements have pulled Mexico away from such growth-oriented policies as tax cuts and freer trade 7. For an overview of this issue, see Edward L. Hudgins, "An Agenda for the IMF Conference," Heritage Foundation Backarounder No. 381, Sep t ember 21, 1984 7THE ROLE OF THE BANKS During the 1982 phase of the Mexican debt crisis, there was a Profits for eight major real danger that defaults by large debtor countries could undermine major U.S. banks heavily exposed in Latin America. Today, howev er, the banks are in much better financial shape.
U.S. money center banks with ;Large,Latin American investments rose an average of 25 percent during 1985 stock has climbed an average of 80 percent since the end of 1982, and dividends increased during the same period by 45 percent As profit-seeking businesses these banks took risks in lending money to the governments of developing countries thought that since governments are unlikely to go bankrupt, their loans would be safe risk knowingly, expecting to ma k e profits. It is proper, of course for these banks to seek repayment of their loans proper for the U.S. government, nor is it in America's economic interests, to relieve the banks of losses due to poor business judgment, either through taxpayer-financed b a ilouts or .by pressuring Mexico to cripple its economy to meet debt payment schedules The price per share of their Many banks no doubt That was a decision made by bankers who.took the But it is not RECOMMENDATIONS The objective of U.S. policy toward Mexic o and other debtor countries should be to restore their international financial soundness by fostering growth and private enterprise. .It should not be to protect businessmen and investors, including bankers, from their own bad judgment. Thus the Reagan Ad m inistration's policy towards Mexico in the current crisis should incorporate five basic strategies 1) SUDDO~~ onlv a n IMF nroura m that nromotes economic arowth The Baker Plan seeks to move away from the austerity policies of the past toward an emphasis on economic growth through free market reforms. This new strategy now faces its first great test in Mexico.
If the IMF, with U.S. support, saddles Mexico with loan conditions that sacrifice long-term development for short-term gains, the Baker Plan will cr umble along with the Mexican economy 8. Figures based on "The Impact of the Latin American Debt Crisis on the U.S. Economy a staff report of the Joint Economic Committee of Congress, May 10, 19
86. Note: Due to its special situation, Continental Illinois was left out of these calculations 82) Reauire the U.S. ba nks to work out their own arranaements with Mexico.
The U.S. government has no.obligation to protect American banks--or any other industry--from losses due to bad busines s decisions. government of Mexico They have many options. For one thing, the banks could extend new loans and roll over old ones. For another they could cut their interest rate spreads-the profit margins on their loans--as any other industry would when it s market contracts.
The banks also could consider a negotiated interest payment cap. For example, they could agree to accept interest payments of 25 percent of Mexico's export earnings. .Combined with writedowns and reductions in overall outstanding princi pal, banks could still profit underfthis arrangement. While this latter option is the least desirable choice and would set a bad precedent, it would be less disastrous than bankruptcy The banks should work out whatever deal they can with the 3) Promote de bt/eauitv swans.
The Mexican government has shown wisdom in allowing foreign businesses to swap portions of Mexico's debt purchased from creditor banks for government equity in Mexican companies. The U.S. Commerce Department should alert interested U.S. bu sinesses of this possibility and provide them with the appropriate technical information. U.S banks currently are prohibited from owning equity shares in any businesses, Mexican or American. Yet debt/equity swaps between the banks and the Mexicans would e a se further the debt problem and probably fit in well with Mexican attempts to privatize state-owned enterprises. Congress thus should amend the Glass-Steagall Act, which forbids equity ownership by banks, to enable U.S. banks to take possession of equity in Mexican companies under the debt/equity swap arrangement 4) Continue to encouraae Mexico to make market-oriented economic reforms.
The Mexican government is under intense internal pressure to stay with the failed socialist policies of the past. But without basic reforms, easier IMF conditions and bank concessions. are worthless,.
The Reagan Administration therefore must continue to encourage receptive Mexican leaders to make market-oriented reforms.
Mexicans are sensitive about foreign pressure, especially from the U.S., this encouragement should be discreet. Public criticism of Mexico is likely to be counterproductive and should be avoided.
U.S. also should ask the Western Europeans and Japan to tender free market suggestions Since the The 95) Exnlore further sDecial free trade and investment arranuements.
The success of the maauiladora system is a base for further expansion of free trade and investment. Currently, all finished products from maauiladora factories must be re-exported to the U.S.
It wo uld be better if Mexico would allow some of these goods to enter the Mexican market. In exchange, the U.S. could cut further the duties on the value of labor added to the products. The possibility of complete free trade and investment zones also should be explored.
Ultimately, a complete Free Trade Area between the'U.S. and Mexico should be sought, similar to the U.S.-Canada pact now being negotiated.
CONCLUSION Mexico's economic problems are extremely serious While the oil price drop was the immediate cause of the current difficulties Mexico's own statist economic policies are at the root of its problems.
Mexico. To the contrary are too high free enterprise principles that will restore its economy. Otherwise the U.S. will soon have far more than merely a n economic problem on its southern border But this does not mean that the U.S. can turn its back on The economic and security interests at stake The U.S. must encourage Mexico to embrace the sound Edward L. Hudgins, Ph.D. a Walker Fellow in Economics 10 -