The very day Robert Rubin was sworn as the Secretary of the Treasury,

the news about the Mexico imminent threat of default arrived. He proposed to the President a risky intervention: to provide Mexican government with billions of dollars, in order to avoid collapse. If Mexico defaulted on its foreign obligations, the flow of capital out of Mexico would probably accelerate and the peso would collapse, triggering severe inflation and a long recession and severe unemployment. As Mexico is the third trading partner for US, this would imply consequences for US as well, such as a rise in immigration by 30% and probably an increase in illegal drug traffic.

The fear of Mexico default could start a chain reaction also into the developing markets, process called “The Tequila Effect”, pulling back investors from all the developing markets, thus affecting the economic conditions in the US, as about 40% of its trade is done with these countries. In the worst case scenario, this could induce from 0.5 to 1% of decrease in growth in US (per year). Mexico was also seen as a role model for the underdeveloped countries pursuing economic reform under NAFTA, and a public failure would set back the market based economic reforms.

The solution would be to provide Mexico with billions of dollars in loan guarantees through the IMF. The risk was that the rescue package wouldn’t work: it could only help American and European investors that were speculators on these crisis markets and there was a political risk as well – the one of reelection in 1996.

The Mexican previous government spent 15 billion USD to support the peso at the exchange rate of 3 peso/usd, while the current one allowed it to float freely. This led to only 6 billion foreign exchange reserves and more than that in short-term debts. The peso fell at 5/usd rapidly and investors were selling Mexican bonds and pesos, while the authorities lost control. Another unintended consequence of the intervention could be “moral hazard”, meaning that in the future anybody could expect such an intervention.

The cause of the crisis was too much borrowing, issuing dollar-linked debt and spending limited dollar reserves to hold the peso at a fixed exchange rate. The current account deficit started to expand since 1990. The government started to issue Tesobonos, short-term obligations linked to dollar. A violent insurgency and 2 political assassinations aggravated the riskiness of these obligations.

The goal was to allow Mexico to restructure its debt from short term to long term and reestablish financial stability and access to capital. The Bank of Mexico was also required to pay significant interests on the loans and make revenues from oil sales to US. IMF negotiated a 2% per month interest rate and inflation was expected to be 4-5 %. The amount to be loaned was 20 bill. Usd.

Within a year, Mexico recovered and started to pay back the loans.