While the Mexican economy suffered from a moderately overvalued exchange rate, the Mexican economy is fundamentally sound. Mexican current account deficits have not placed the country in danger of insolvency. Fiscal policy between 1990 and 1994 has been prudent. Given its improvements in productivity and international competitiveness, and with the passage of NAFTA its access to U.S. markets, Mexico is well-posed to follow a path of export-led growth.
The Mexican economic crisis was the result of policy mistakes that led to an investor panic. The assassination of presidential candidate Donaldo Colosio caused foreign investors to demand a higher return on investments to compensate for increased perceived risk. The Mexican central bank fought the increase in interest rates through an expansion of domestic credit. This credit was converted to dollars and led to a drain on Central Bank foreign exchange reserves. Meanwhile the exchange rate remained moderately over-valued. Moreover, the Mexican government rolled over its short-term peso-denominated debt into short-term dollar denominated debt in an attempt to decrease the cost of government borrowing.
The result of Mexican economic policy in 1994 was to place the economy in a vulnerable position with respect to its external debt: the government held a large amount of short-term dollar donominated debt, reserves had dwindled, and expectations of a devaluation had developed. Once the first devaluation was announced on December 20, investors panicked and ran from the peso. The peso value of dollar-denominated government debt rose sharply, as did interest rates for new government debt. The result was a government liquidity crisis. This crisis in turn contaminated the private sector's credit-worthiness and created the threat of a collapse of the banking system.
With appropriate Mexican economic policy and international support, investor confidence in Mexico can be restored. The bottom line: