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1016 January 25,1995 INTR THE BAILOUT OF MEXICO A COSTLY MISTAKE DUCTION congress should hold off approving the $40 billion in loan guarantees for Mexico.
The Clinton Administrations proposed bailout plan for Mexico will only postpone a fi nal reckoning for Mexicos state-control led economy at great potential cost to U.S. tax payers. It will not fix the underlying structural weaknesses of the Mexican economy that caused the collapse of the Mexican peso in the first place. The emergency economic re forms proposed by Mexican Presid e nt Ernest0 Zedillo Ponce de Leon on January 3 1995, will not fix the countrys problems either. Zedillos emergency program does not go far enough, reflecting the continued resistance of Mexicos traditional business and la bor elites to free-market reforms that threaten their way of life. Before rushing into ap proval of the Clinton bailout plan, Congress should pause and examine the causes of the Mexican failure and ask whether Clintons remedy will work.
There are many reasons to believe that it will not. T he proposed loan guarantees may bail out Mexico this year, but they will not prevent another crisis unless the Mexican gov ernment corrects the fundamental structural problems that caused the pesos collapse. If the Mexican government fails to change the s t ructure of the economy, the bailout will be only a temporary quick fix. A year or two from now, the Mexicans will be back asking for yet more credits to relieve them of yet another debt crisis. This debt relief package may keep the patient out of the emer gency room for a year or so, but if history is any in dication, it will only be a matter of time before the patient ends up back in the hospital.
Mexico has a long history of recurring debt crises involving defaults, reschedulings, and new money loans, som etimes combined with actual reductions of principal 1 Walker F. Todd, A History of International Lending, Research in Financial Services, Private and Public Policy, Vol. 3 JAI Press, 1991. pp. 201-2
89. In this century alone, Mexico was in default on most of its foreign debts from 1914 until 19
30. In 1942 and 1946, Mexico negotiated a 90 percent reduction of foreign debt principal. Meanwhile, Mexican oil The economic disease afflicting the patient is an overly centralized and still heavily regulated econ omy. Notwithstanding the progress Mexico has made in economic reform and that progress is real-its economy is still mostly unfree. The Mexican peso col lapsed not because of the free-market pressures created by the North American Free Trade Agreement (NAF T A but because the Mexican government artificially inflated the value of the peso for political reasons-that is, to help secure the victory of Ernest0 Zedillo Ponce de Leon, the candidate of the long-ruling Institutional Revolutionary Party PRI), in the pr esidential elections of August 2 1, 19
94. This old-fashioned manipulation of the economy is still quite prevalent in Latin America. In order to get Mexicos econ omy on track, major economic surgery must be undertaken. The last thing Mexico needs is a heav y dose of debt-relief narcotics that eases the pain for now but does nothing to cure the underlying ailment.
To avoid debt crises in the future, the first step is to restore confidence in the stability of the Mexican peso and the credibility of the Mexica n governments monetary authori ties. To do this, the Zedillo administration should consider replacing the Banco de Mex ico with a currency board. The pesos convertibility would be linked to the U.S. dollar at a fixed rate3 and could be capitalized with pa r t of the earnings from the governments pri vatization plan, which should be expanded to include the state-owned petroleum and elec trical power industries. In addition to a currency board and more aggressive privatiza tion, the Mexican government should r e form the tax system, slashing personal and corpo rate taxes to stimulate more investment. President Zedillo also should abolish all wage and price controls and eliminate the economic stability pacts negotiated annually by the government with a small group of business and labor elites. Finally, Mexico must create the conditions for domestic savings growth and a more equitable distribution of income by privatizing the inefficient social security system and creating private pension funds for the social securi t y benefits of Mexican workers. A strong domestic savings sector would provide a new source of funds for investment in Mexicos development and growth, reducing the countrys excessive reliance on foreign capital sources to finance Mexicos economic developme nt.
At the very least these measures should be conditions for granting the loan guarantees to Mexico. But the problem with conditions is that Mexico gets the debt relief now while the U.S. has to wait for years to see whether the reforms are being made. In the mean time, after the loan guarantees are approved, the U.S. loses leverage over Mexico that cannot be regained until another debt crisis occurs and the request for further debt relief is made. On top of that, Mexicans resist conditions being imposed on them. For domestic 2 nationalization claims of 1938 were not fully resolved until 19
59. Mexico defaulted again in 1982, triggering the Latin American debt crisis.The bonds-for-debt exchange under the Brady Plan in March 1990 reduced Mexicos external debt to about $91 billion, from $103 billion at year-end 19
89. Since 1990, Mexicos total foreign debt has increased to $160 billion.
BryanT. Johnson and Thomas P. Sheehy, The Index of Economic Freedom (Washington, D.C The Heritage Foundation 1995 p. 157 D lespite the NAFTA, Mexico still imposes limits on economic freedom Mexicos political system has not been reformed as rapidly as its economy Government corruption continues The fixed rate could be one peso per U.S. dollar, or 3.5 pesos to the dollar, and t h e currency board could be capitalized by pledging part of the assets of the state oil monopoly Petroleos Mexicanos (Pemex) and the electrical power monopoly Comision Federal de Electricidad (CFE 2 3 2 political purposes, President Zedillo will resist agre eing to U.S. conditions because he will not want to be seen as kowtowing to Yankee pressures from the North.
There is clearly no easy solution to the Mexican economic crisis. But one thing is cer tain: throwing good money after bad will not solve the probl em. There is no reason to rush into a decision without first understanding all of its ramifications. Congress should pause and consider the wisdom of a policy that not only may not work, but could need lessly cost American taxpayers billions of dollars TH E CLINTON BAILOUT PLAN The Clinton and Zedillo administrations are telling congressional leaders, the Ameri can people, and international investors that the pesos nearly 40 percent devaluation since December 19, 1994, is a temporary liquidity shortage that will end as soon as confi dence in the Mexican economy recovers. To restore confidence, they assert, Mexico must borrow tens of billions of dollars so that it can repay tens of billions of dollars in debt ob ligations maturing during 19
95. If the U.S.-backed loan guarantees are not approved quickly, they warn, Mexico may become insolvent and be forced to declare a debt mora torium, which could unleash a new debt crisis throughout Latin America and a huge wave of illegal Mexican migratio n to the United States.
Since the pesos meltdown one month ago, the bailout package cobbled together by the Clinton Administration has swelled to $58 billion? which is equivalent proportion ally to 36.2 percent of Mexicos total foreign debt. However, this may not be enough to cover all of the debts coming due in Mexico this year.
To fix the Mexican crisis, President Zedillo has proposed a two-month emergency planJ that includes restrictions on wage increases; government spending cuts equiva lent to 5.2 per cent of the budget, or about $3.75 billion; an increase in the corporate tax rate from 34 percent to 35 percent, plus higher income taxes for upper-bracket taxpayers and an increased tax on luxury automobiles; higher rates and prices for publicly provided goods and services; and the privatization of a broad range of government-owned assets including railways, petrochemical plants, ports, satellite systems, power plants, and toll roads. Mexicos new Finance Minister, Guillermo Ortiz, told foreign investors a n d bank 6 7 After the Mexican Crash, Baring Securities Inc New York, January IO, 1995.The report estimates that Mexicos projected foreign debt obligations for all of 1995 include $9 billion of public sector debt; $15.9 billion of foreign-owned Tesobonos (s h ort-term MexicanT-bills guaranteed in U.S. dollars 9.6 billion of private sector debt; and $5.1 billion of Cetes and Ajusta-Bonos. Cetes are short-term peso notes and Ajusta-Bonos are linked to the Mexican consumer price index. Latin American Weekly Repon , Two-month plan will take a bit longer, Latin American Newsletters, January 19, 1995.
Workers earning the minimum salary (IO percent of the economically active population) will receive a 4 percent increase raising their daily wage this year to slightly ov er $3, and will be able to negotiate a further 3 percent increase against higher productivity. Those earning up to two minimum salaries (61 percent of the workforce) will also get a refund equivalent to 3 percent of deducted income tax. This compares to a new official inflation target of no more than 16 percent for 1995, although independent analysts in the United States and Mexico project that inflation may average at least 20 percent, and possibly more if the peso fails to stabilize at the Zedillo govern ments projected level of 4.5 to the dollar.
The government has pledged that such increases will be by an amount lower than devaluation 3 ers in New York that the government expects to raise at least $14 billion from these planned privatizations. schemes, w hich have in some cases been stalled for years. Moreover, the Zedillo ad ministration will not be able to sell any of these assets quickly; nor will it earn the full 14 billion projected by Finance Minister Ortiz. The pesos meltdown and the resulting econ o mic crisis have destroyed investor perceptions that Mexico was a stable economy which means that market valuations of the assets up for sale may be significantly lower than the Zedillo administration has projected in its plan. More important, the assets o f greatest real value-the oil monopoly Petroleos Mexicanos (Pemex) and the state-owned power utility Comision Federal de Electricidad (CFE)-are not part of the privatization scheme.
The Mexican government predicts that its economic reforms will result in a gross do mestic product growth rate of l .5 percent to 2 percent for 1995, an inflation rate below 16 percent, an exchange rate of 4.50 pesos per U.S. dollar (compared to 5.586.63 on January 20, 1995 and a 50 percent reduction this year in Mexicos curren t account defi cit. It also predicts that exports will rise by 16 percent in 1995 (compared to 7.4 percent last year while imports will increase by 13.2 percent.
However, these official projections may be too optimistic. Measured in U.S. dollars the collapse of the peso has evaporated nearly 40 percent of Mexicos national wealth.
Even with the U.S. loan guarantees, Mexicans will not recover from this blow for many years, For Mexico, the immediate outlook probably will include zero to negative eco nomic gro wth, higher inflation, more unemployment, depressed demand, and increased illegal migration to the U.S.
A conclusion is inescapable: The Zedillo reform plan will not have the desired effect.
It will not produce the projected rates of economic growth and, as a result, will not get Mexico out of its economic crisis. Thus, even if the loan guarantees are approved, Mex ico will still be in deep economic trouble. There is little reason to believe that the Zedillo plan will restore confidence in Mexicos suffer i ng economy However, these proposed privatizations are little more than a repackaging of existing 9 A FREE MARKET CURE L The cure for the Mexican crisis is in Mexico City, not in Washington. While the loan guarantees would ease the pressures on the peso an d on the Zedillo presidency, they will not tackle the underlying problems of Mexicos economy. Only President Zedillo can do that. To get the crisis under control, President Zedillo needs to I/ Convince the Mexican people and the world that he is capable of leading Mex ico out of this crisis. If Zedillo does not reassert his leadership, his presidency in all probability is doomed, and Mexicos economic modernization will stall for years. To 8 9 Daniel Dombey, Underwhelming Proposals, Business Latin ArnericdIl e Economist Intelligence Unit, January 16, 1995.
Kevin G. Hall, Exports Seen as Crucial to Ending Mexicos Peso Devaluation Crisis. The Journal of Commerce, January 6, 1995 4 assert his presidential leadership, Zedillo must act swiftly to terminate the simm ering crisis in Chiapas where the Zapatista rebels are challenging government authority.
Negotiations with the rebels have dragged on for a year, and it is clear that the aim of rebel leader Subcomandante Marcos is to prolong the conflict indefinitely and to destabilize Mexico by undermining the authority of the presidency and strengthening internal political and popular opposition to the countrys economic and democratic modernization. The Chiapas rebellion contributed to the collapse of the peso by great ly undermining investor confidence in Mexicos economy.
To end the Chiapas conflict and to restore confidence in the Mexican economy and President Zedillos leadership, the Mexican President should announce a dead line for a binding negotiated settlement. In addition, the Zapatistas should be offered the opportunity to join the democratic process, either by creating their own political party or by joining existing parties. After the final deadline for a settlement passes President Zedillo should order the Me xican army to occupy the rebel strongholds and disarm the Zapatistas by whatever means are necessary.
In addition, President Zedillo should consider the following structural economic re forms to restore confidence in Mexico and prevent yet another debt crisis in just a few years d Replace the Bank of Mexico with a Currency Board. Because the Bank of Mex i c o failed to maintain a stable currency, it is time to look at alternatives. One idea is a currency board. A currency board issues a local currency that is fully backed by re serve assets denominated in a widely used and well-respected foreign currency, su c h as the U.S. dollar. The local currency-in this case the peso-could be converted into the reserve currency-in this case the dollar-at a pre-established fixed rate at any of the boards offices. Under a currency board, the local currency supply can ex pand only in proportion to an increase in net exports or capital inflows. As a result the inflation and interest rates in the local currency will closely resemble those rates in the country that supplies the reserve currency. A currency board invests its re se r ves in high-quality, interest-bearing notes and bonds denominated in the reserve currency. These earnings should more than cover the boards operating expenses be held in U.S. dollar assets, would immediately reassure the Mexican market and re store confid e nce in the peso. Inflation and interest rates now likely to soar instead would subside to rates similar to those in the United States. Selling part of the state owned oil monopoly Petroleos Mexicanos (Pemex) and the electrical power monop oly Comision Fed eral de Electricidad, could capitalize a currency board more than adequately.
Over sixty countries have had currency boards during this century. Argentina has been using a variant of the currency board since 19
91. In each of these cases, a cur rency boar d system killed the deadly virus of high inflation, lowered local interest rates to manageable levels, and encouraged direct foreign investment in the local economy. Institution of a currency board in Mexico may be the most important re form that the Zedi l lo government could initiate Replacement of the Bank of Mexico with a currency board, whose reserves could 5 d Be more aggressive in privatizing state-owned monopolies. Privatizing the state owned .oil and electricity monopolies has been taboo in Mexico. T here are even con stitutional restrictions on doing so. However, if Mexico is to solve its economic cri sis, the Zedillo administration must begin to privatize Pemex and CFE. The assets gained from selling these monopolies to the private sector of the eco n omy could be used not only to capitalize a currency board, but also to capitalize the private pension funds that would result from privatization of the social security system and to help re pay part of Mexicos huge foreign debt d Overhaul Mexicos tax syst e m. Mexicos progressive income tax regime, which be gins taxing income at $5,000 a year and rises progressively to 34 percent for individ ual taxpayers, should be replaced with a flat tax of 17 percent. The corporate in come tax, which Zedillo proposes to r aise to 35 percent from 34 percent, should be halved to a flat rate of 17 percent. The corporate assets tax, now at 1.6 percent from 2 percent originally, should be eliminated. The value-added tax, now at 10 percent should be reduced to 8 percent. l2 Mexi c o also should follow the example of the AsianTigers and eliminate all capital gains taxes.13 these one-year wage and price stabilization pacts have been renewed annually in high-level negotiations between the government, organized labor, and business. Es s entially manifestations of the corporatist state, these pacts are incompatible with the free-market model Mexico purports to be following. All wage and price controls should be abolished, allowing market forces to set wage and price levels in the Mexi can economy d Privatize the social security system. Mexico needs to reduce its excessive reliance on short-term capital inflows from abroad and develop new domestic funding sources for productive investments. In addition, one of the key challenges facing the Z edillo administration is to start correcting the unequal distribution of income in Mexico. Privatizing the social security system would accomplish all of these objec tives A privatized social security system based on the Chilean model of privately man age d pension funds could be capitalized by selling off part or all of the assets of Pe mex and CFE. The creation of privately managed pension funds also would promote the growth of a healthy and diversified equities market that could draw on the sav ings of M e xican workers, rather than foreign lenders and investors, to finance the growth and development of the Mexican economy. In turn, this would reduce in come inequality in Mexico, fostering the emergence of a strong middle class and cre ating the bases of fo r mal, individual property rights essential to a sound free-market economy d Abolish the economic and social stabilization pacts. Begun in the mid-1980sY 10 In Mexicos case, the reserve currency should be the U.S. dollar 11 The income tax withholding floor a lso should be increased from $5.000 to $10,000 12 This would improve Zedillos low popularity with the Mexican people 13 Currently, only companies listed on the Mexican stock exchange are exempted from capital gains taxes 6 CONCLUSION I Unless these reform s are enacted, any debt relief package would only prolong Mex icos long-term structural problems with its economy. As Congress debates the wisdom of the Clinton plan, it should focus on what Mexico can do to solve its own problems.
However, making these me asures conditions for assistance is problematic. The Mexicans will probably reject outright conditionality, and even if the conditions were accepted there is no guarantee that they will acted upon in the future unfair to the American people as well. The U . S. government is not bailing out Califor nias Orange County, which is bankrupt today because of the unwise investment deci sions of its financial managers. Similarly, the U.S. government does not make a habit of bailing out private investors who lose mone y on speculative investments.14 Yet that is precisely what will happen if the loan guarantees are approved. The full implications of the Clinton plan should be aired by Congress, including the downside to letting Mexico default on its loans in the absence o f the loan guarantees, but if the November elections showed anything it is that business as usual is no longer the order of the day. Congress should take a cold, hard look at the bailout plan before risking billions of taxpayer dol lars on a scheme that m o st likely will do nothing to solve Mexicos economic problems In the end, the Clinton bailout plan seems not only unwise economically, but patently John P. Sweeney Policy Analyst 14 U.S. investors have lost at least $25 billion on their Mexican investments since the peso was devalued on December 19 1994 7