Thayer Watkins

Financial and Economic Crisis in Mexico in 1982

To understand the nature of the financial crisis of Mexico in the 1980's it is necessary to consider what was happening in the petroleum industry in the 1970's and the effect those events had on the world's economies in the 1980's. The story of the emergence of the industries for finding, refining and marketing petroleum is told elsewhere. By the 1960's the countries of the Middle East decided that they wanted a bigger share of the value of the petroleum that multinational oil companies had found in their countries. Those countries and others formed in 1960 the Organization of Petroleum Exporting Countries (OPEC) to try to create a cartel. Not all petroleum exporting countries joined OPEC. In particular, the Soviet Union and Mexico did not join. OPEC was largely ineffective in gaining any larger payment from the petroleum being produced in their countries until about 1973. In 1973 the Shah of Iran led a movement to increase the price of petroleum by several hundred percent. In order to increase the price of petroleum OPEC would have to reduce the amount which was being put on the market. It was not easy to arrange a cutback in production because most of the countries in OPEC wanted to sell more if the price was going to be higher rather than less. The petroleum-exporting countries which were not in OPEC would expand their production in response to any higher price. This is why it took from 1960 to 1973 for OPEC to have an impact on the price of petroleum. The cutback in production and price rise in 1973 only was possible because Saudi Arabia agreed to take the lion's share of the cutbacks.

With the rise in petroleum prices in the mid1970's came a flood of dollars to the petroleum-exporting countries, OPEC countries and non-OPEC countries. In some of those countries there was more funds available than could be utilized within the country so the excess was channeled into American and Western European banks where they were known as petrodollars. The banks in turn were flooded with petrodollars and were scrambling to find places to put the money to work to earn interest.

Countries such as Mexico which were petroleum exprters found it very easy to gain loans. the Government of Mexico found that it not only had vastly more revenue from its petroleum exports but it also could borrow vast amounts from international banks. Mexico has a great need for capital investments, both public and private. With the aboundance of funds that were available there seemed to be no need to turn down any investment project.

Many projects were funded of doubtful validity; i.e., some projects were not well conceived or properly executed. Some, even if they were honestly administered, would not generate more benefits than their costs. Some projects were executed to allow bad economic policies to continue. For example, Mexico City had a problem with water shortage and water development projects were created to bring water to Mexico City from farther and farther away. The real problem is that residential water use in Mexico City was not metered. Residents paid a flat fee and the fee did not go as they used more and more water. There was nothing to discourage middle and upper income families from creating landscaping that required vast amounts of water. To make matters worse the more water the city used the more waste water there was to dispose of. Mexico City lies at the bottom of a basin so the waste water had to be pumped uphill to dispose of it. This required electrical power.

The policy of providing water to Mexico City residents at zero marginal cost is a bad policy. Solution is to install water meters to impose the real cost of water on the users. The solution definitely was not one of paying for more and more expensive water to market to the residents at zero marginal cost. Yet that was what Mexico was doing in the late 1970's.

The rise in petroleum prices became even larger in 1979 when the Iranian Revolution took Iran's petroleum production off the market for a few years. That price rise accelerated Mexico's borrowing. Mexico's debt mounted and the interest payments on it grew. This did not seem to be a problem.

Suddenly Paul Volcker, the Chairman of the Board of Governors of the Federal Reserve Bank of the United States, implement a new, tight monetary policy. The rise in petroleum prices drove up the rate of inflation. Moderate measures of anti-inflation policy were not working and so Paul Volcker decided to institute strict monetarist monetary policy no matter what happened to interest rates. Restrictions on the growth rate of the money supply brought the prime interest rate, the interest rate banks charge their best commercial customers, from a level of about twelve percent to a level of about 24 percent. Borrowers who had adjustable or floating interest rate loans found suddenly that their interest payment had doubled.

One of the borrowers who had escalating interest payments was Mexico. At the same time that Mexico's interest costs went up its income from petroleum sales started to go down.

The quantity of petroleum supplied to the market went up due to, in part, Iranian production coming back on the market. Non-OPEC countries were expanding their production. The price of petroleum began to fall.

There were two other effects of Volcker's tight monetary policy that affected Mexico. The high interest rates in the U.S. discouraged investment and produced a recession. It is said that when the U.S. economy catches a cold the economies of its Third World trading partners come down with pneumonia. The recession in the U.S. produced a downturn in the economy of Mexico. Furthermore, the high real interest rates in the U.S. encouraged those with investible funds to convert them into dollars for investment in the U.S. financial markets. The end result is that the value of the dollar increased with respect to foreign currencies such as the Mexican peso. If the loan payments for Mexico were denominated in dollars then the decreased value of the peso with respect to the dollar meant that it took more pesos make the same dollar payment. With increased dollar payments to cover the higher interest rates it meant a lot more pesos were required. In 1982 Mexico was in deep financial crisis.

To be continued.

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