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520 June 30, 1986 A US, STRATEGY TO SOLVE MEXICO'S DEBT CRISISINTRODUCTION Mexico's irternational debt problems are once againmaking Wall Street nervous. The roots of the current crisis-go.backat least a decade, but the problem first reached a critical stagein 'August 1982 when Mexico was unable to meet interest payments onits then $80 billion.debt. In response, th e country's creditorsrescheduled Mexico's loans and devised a plan to reduce Mexico'scrushing debt burden. This included an austerity strategy imposedby the International Monetary Fund (IMF). Despite these efforts (orbecause of them) Mexico's external debt now has mushroomed to over98 billion and the country again faces possible default when $1.8billion 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 growthpulls developing nations out of the debt quagmire and puts them onthe road to prosperity. Translating this sound counsel int opolicy, Treasury Secretary James Baker has made his proposed $20billion in new private loans and $9 billion in new internationalorganizations loans to debtor countries contingent on those nationsadopting market-oriented economic reforms. In the contex t of theBaker Plan, Reagan Administration officials are working with theirMexican'counterparts IMF and World Bank officials, and privatebankers on Mexico's crisis 1. For an overview of the debt crisis,see Esther Hannon and Edward L. Hudgins, "A US. Str ategy for LatinAmerica's Debts Heritage Foundation Backarounder No. 502, April 7,1986.
No doubt they will fashion.some short-term arrangement to helpMexico through the difficult months ahead more than mere words, theReagan Administration must develop a growth-oriented economic planfor Mexico-otherwise an even greater Mexican crisis will explode inthe future But if the Baker Plan is to be Mexico's current problemsare a culmination of structural deficiencies in its internaleconomic policies and the r e sult of recent economic and politicalshocks. The most immediate factor is the 50 percent drop in oilprices since late last year sharply revenues from Mexican oilexports, which are critical to the country's foreign exchangeearnings, thus making it very difficult for Mexico to meet its debtobligations underlying factors stem from Mexico's huge publicsector, from massive state intervention into the economy, and fromrestrictive trade and investment policies. Admittedly, there havebeen signs of positive change in recent years. Budget cuts, forexample, have been made.
Plans exist to sell to the private sector or close variousmoney-losing state industries. Some investment rules have beenrelaxed. Freer trade is at least being considered. And special factories near the U..S. border, called maailadoras, governed byspecial trade and investment laws, are prospering. But thesechanges have been too small as yet to overcome Mexico's economicwoes.
IMF austerity plan under which Mexico has operated for over three years has squeezed hard currency out of the.country for debtpayments yet failed to promote economic growth. Learning from thisexperience the Reagan Administration should support a new IMFstrategy for Mexico only if it promotes economic growth rathe rthan economic contraction.
The Administration should not be overly concerned about lossessuffered by Mexico's creditor banks, for the U.S. banking system isnot currently in danger of collapse. The banks are capable ofdealing with the debt situation on their own, relying on soundbusiness principles instead of government help This has cutAlthough the oil price change has provoked the crisis, theInternational help, meanwhile, has been a mixed blessing. The Asound U.S. strategy for the Mexican debt cr i sis should be rootedin the Baker Plan. It could encourage, for example, a technique forreducing state holdings in the economy: foreign or Mexican.privatebusinesses purchase Mexican debt from ban.ks and forgive the debtin exchange for Mexican governmen t-owned equity in Mexicanbusinesses.
The Administration also could encourage Mexico to acceleratemarket-oriented reforms and structural economic adjustment. Amongthese are reducing the size of the public sector, deregulating theeconomy, and cutting tax es. And the U.S. could seek expansion ofthe macruiladora factory system and offer to cooperate in theestablishment of complete free trade and investment zones 2TheMexican people want and deserve the opportunity to work and toprosper needs. Yet the cur r ent crisis offers Mexico the chance tochange directions, to follow the kind of growth-oriented policiesthat have helped many of the developing countries of the PacificRim and are capturing the imaginations of many others. Only a freemarket strategy wi l l create new, productive jobs, improve Mexicanbusiness and labor efficiency, and spur real, non-inflationaryeconomic growth to prosper and to meet its debt obligations Butpast statist policies have failed to meet these Only aneconomically.dynamic and g rowing Mexico will be able THE CURRENTDILEMMA Of Mexico's $98 billion foreign debt, nearly $75 billion isowed to commercial banks, with U.S. banks holding about one-thirdof the IOUs. The rest is owed to other banks worldwide. In thepast, Mexico has ke p t up its interest payments and has beenconsidered the ''good pupil'l among the debtor nations. This yearMexico will.owe approximately-$9.2 billion in interest payments,with $1.8 billion due on June 30 last year's $10.1 billion, thanksto lower interest rates, the 50 percent drop in oil prices hasslashed Mexico's export oil earnings from $14.7 billion in 1985 toabout around $7 billion this year.
Mexico thus faces a 25 percent real decline in governmentrevenues While this year's total debt service amou nt is down fromMexico is seeking between $6 billion and $8 billion in new loansand concessions (for example, on interest rate spreads But theReagan Administration maintains that most of this shortfall can bemade up by Mexican cash on hand plus additio nal Mexican budgetcuts.
Indeed, Mexico's cash balances are believed to total perhapsaround $6 billion. Nonetheless, Mexico is seeking $2.5 billion innew foreign commercial bank loans, $1 billion each from the IMF andWorld Bank and about $600 million fr om the Paris Club, an informalgroup of government creditors. At this point, direct U.S. aid isnot anticipated AMERICA 1 S ECONOMIC INTEREST IN MEXICO Mexico'seconomic difficulties pose a real, though limited threat to theU.S. economy partner, selling the U.S. mainly oil, machinery, andtransportation equipment Mexico is America's third largest tradingTo accumulate currency to pay its debts, Mexico has been I3reducing purchases of U.S. goods from $17.8 billion in 1981 toonly $9 billion in 19
83. And while sales were back up to $13.6 billion by 1985, theyare likely to decline again this year American saies to Mfxicodropped Manufacturers of U.S. machinery and transport equipmenthave been badly hit, with sales dropping from $8.7 billion in 1982to $3 .7 billion in 19
83. Sales from this sector recovered only up to $6.6 billion in1985 U.S. farmers, struggling with their own debt problems, alsohave suffered heavily. The initial'crisis in 1982 cut U.S.agricultural sales to Mexico from $1.9 billion to o nly $680million: And.by 1985 sales were still only $920 million. Clearly,an economically strong and prosperous Mexico is better able topurchase U.S. goods and create American jobs. A stagnant Mexicopurchases little and adds to America's export problem s U.S.SECURITY INTEREST IN MEXICO The economic crisis in Mexico iscreating serious social and political problems t$at could triggerunrest, posing a security problem for.the U.S The economic crisisin Mexico is creating serious social and political probl e ms t$atcould trigger unrest, posing a security problem for.the U.SMexico's economy will contract this year for the third time in thelast five years have increased unemployment, while real wages forthose employed have dropped and the standard of living has slippedback 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 flightof capital, the state-owned banking system halted nearly all newcredit to Mexican businesses.
This, of course,'cut investment further. Inflation also has beena chronic problem. And prices for basic food products have in somecases qua drupled endemic and on the rise The debt crisis and theIMF austerity measures Malnutrition and health problems among thepoor are Mexicans are frustrated that there seems to be no end insight to the economic hardship. For the first time since the 1910 re volution which estab1ished:the current system of government, thelegitimacy of 2. Trade figures in this section are from Latin American Trade Re view 1985: A U.S PersDectivg (Washington, D.C U.S.Department of Commerce, International Trade Administration 3. Foran overview of these problems, see Mary Williams Walsh and S.Karene Witcher As Debt Turmoil Ebbs and Flows in Mexico, HumanMisery Persists The Wa I1 Street Jou rnal June 12, 1986 4thegovernment is being seriously questioned election fraud undert aken by the ruling Institutional Revolutionary Party (PRI) againstthe opposition conservative National Action Party PAN) have-inte-nsified political divisions. Even more serious perhaps, aregrowing divisions within the PRI itself. The PRI normally gover n sby a consensus of'the var'ious interest groups including organizedlabor, party intellectuals, and government bureaucrats. Now theseelements, nearly all more leftist than Mexican President Miguel dela Madrid, openly criticize the government and call f or moreradical socialist approaches to Mexicols economic problems.
While the political stability of Mexico is not yet at stakefurther economic decline could unleash violent social unrest. ThisCharges of widespread would only benefit the left friendly to Cubaand the Soviet Union, driving millions of refugees A radicalleftist regime in Mexico north, would pose one of this centuryismost serious national security problems for the U.S. Further,Mexico is one of America's most important sources of oil impo rts Adisruption of the oil flow because of social unrest or a hostilegovernment would.also pose a serious security threat.
MEXICO'S PAST ECONOMIC ERRORS While falling oil pricesprecipitated the latest crisis, Mexicols economic problems arerooted in its economic system, which relies heavily on socialistand statist economic policies. To take just one barometer of theproblem: the government copsumed about 26 percent of Mexico's GNPin 1970; now it is 50 percent. Because the political power of theruling PRI rests to a great extent on its ability to provide publicsector jobs to supporters, public sector employment has increasedthroughout the debt crisis. The industries and enterprises owned bythe state, meanwhile, have jumped from 86 in 1970 to over 1, 000today. And trade barriers designed to keep out foreign goods toencourage domestic manufacture have only wasted capital and laborand made the Mexican economy less competitive.
Foreign investment and direct foreign ownershi p of Mexicanbusinesses might have been expected to provide an infusion ofcapital and know-how, but such investments have been restrictedsharply by the government. the capital for industry--which thegovernment did by borrowing abroad. The result: Mexic o 's massiveforeign debt. The sudden This has meant that the government had toraise much of 4. Luis Pazos, "The False Austerity Policies of theMexican Government," Journal of Economic Growth, Vol. 1, No. 1,First Quarter, 1986 (Washington, D.C.: National Chamber Foundation5 nationalization of the banks in 1982 by President de la Madrid'serratic predecessor, moreover, contributed to capital flight bydemonstrating that the Mexican government could not be trusted torespect, much less to protect, the righ ts of private property.
Artificial attempts to stimulate economic growth last year byprinting new paper money only accelerated the rise in inflation andthe drop in the peso to about 750 per dollar from 250 per dollarlast July.
RECENT ECONOMIC PROGRESS A number of Mexican statesmen realizethat fundamental economic reform is sorely needed taken. Example: anumber 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 Smallbut important first steps have been Others have been Tg ease partof its debt burden, Mexico is allowing debt-equity swaps foreigncompanies which, in turn, can exchange the debts forgovernment-owned equity in both public and priv ate Mexicancompanies.
At least three such swaps, worth $81 million, already have takenplace. This is an important development. Foreign businesses thatown shares in Mexican companies have strong incentives to see thatsuch companies succeed economically. They are likely to invest morecapital and resources to protect their interests and to opposeinternational action that would constrain the Mexican economyForeign banks sell portions of their Mexican debts to other Helpfulalso will be Mexico's imminent membership in the General Agreementon Tariffs and Trade (GATT the multilateral agreement that governsmost world trade. This could lead to trade liberalization andstepped-up foreign investment. Some restrictions on direct foreigninvestments, in fact, h ave already been eased. Though foreigncompanies normally can own no more than 49 percent of a business inMexico, for example, a 100 percent IBM-owned and operated facilitywas recently approved by the Mexican government.
One market-oriented policy developed over the last decafe knownas the mauuiladora factory system, has been very s~~~essful.
Under this system U.S. companies have established over 700plants in the northern border regions of Mexico without the usualrequirement of 5. See testimony by Ass istant Secretary of the U.S.Treasury David C. Mulford before the Subcommittee on WesternHemisphere Affairs, Senate Foreign Relations Committee, June 101986 6. See Aaron Freiwald Mexico A Multinational Haven,"Multinational Monitor, November 15, 1985 6h a ving Mexican partnersU.S. the capital goods and semi-finished products necessary forproduction without the need to pay Mexican duties these plants'canbe re-exported to the U.S. with tariffs being paid only on thevalue added to the goods take advantage of less expensive Mexicanlabor. These mamiladoras near Mexico's border with the U.S. areamong the few bright spots on a dark Mexican economic landscapeThese plants are allowed to import from the Goods produced in Thisallows U.S. companies to Some crit i cs may charge that Mexico'seconomic reforms are too There is strong little, too late, or meretoken gestures to appease foreign creditors. It is true that thesereforms will not restructure Mexico's economy overnight--nothingcould do that leftist opposi tion to such.reforms. Thus Mexicanleaders must fight tough political battles for even smallsteps.
THE ROLE OF THE IMF For the past three years, Mexico has beencomplying with stiff conditions established by the IMF in exchangefor financtal assistance. B ut IMF requirements are a two-edgedsword. They are meant to generate sufficient hard currency for acountry to keep up its debt payments. But while doing so, they maylead to long-term economic distress. For example, while it iseconomically sound to sla sh a country's budget deficit throughspending cuts, it is economically dangerous to do it by raisingtaxes encourages tax hikes to cut budget deficits.
Yet the IMF often IMF conditions usually require increasingexports-and cutting imports. But this often deprives businesses ofnecessary capital goods obtained only from abroad. And inefficientlocal industries often must make up for lost imported goods whichcould have been purchased far cheaper than the local industry'sproduction costs.
Developing countries, moreover, usually need to impqrt suchresources as money and goods to grow serious long-term economicdamage.
Closing markets to imports thus causes Thanks to such IMFconditions, theref.ore, Mexico is in many ways worse off as aresult of internati onal "help." IMF requirements have pulledMexico away from such growth-oriented policies as tax cuts andfreer trade 7. For an overview of this issue, see Edward L.Hudgins, "An Agenda for the IMF Conference," Heritage FoundationBackarounder No. 381, Sep t ember 21, 1984 7THE ROLE OF THE BANKSDuring the 1982 phase of the Mexican debt crisis, there was aProfits for eight major real danger that defaults by large debtorcountries could undermine major U.S. banks heavily exposed in LatinAmerica. Today, howev er, the banks are in much better financialshape.
U.S. money center banks with ;Large,Latin American investmentsrose an average of 25 percent during 1985 stock has climbed anaverage of 80 percent since the end of 1982, and dividendsincreased during the same period by 45 percent As profit-seekingbusinesses these banks took risks in lending money to thegovernments of developing countries thought that since governmentsare unlikely to go bankrupt, their loans would be safe riskknowingly, expecting to ma k e profits. It is proper, of course forthese banks to seek repayment of their loans proper for the U.S.government, nor is it in America's economic interests, to relievethe banks of losses due to poor business judgment, either throughtaxpayer-financed b a ilouts or .by pressuring Mexico to crippleits economy to meet debt payment schedules The price per share oftheir Many banks no doubt That was a decision made by bankerswho.took the But it is not RECOMMENDATIONS The objective of U.S.policy toward Mexic o and other debtor countries should be torestore their international financial soundness by fostering growthand private enterprise. .It should not be to protect businessmenand investors, including bankers, from their own bad judgment. Thusthe Reagan Ad m inistration's policy towards Mexico in the currentcrisis should incorporate five basic strategies 1) SUDDO~~ onlv a nIMF nroura m that nromotes economic arowth The Baker Plan seeks tomove away from the austerity policies of the past toward anemphasis on economic growth through free market reforms. This newstrategy now faces its first great test in Mexico.
If the IMF, with U.S. support, saddles Mexico with loanconditions that sacrifice long-term development for short-termgains, the Baker Plan will cr umble along with the Mexican economy8. Figures based on "The Impact of the Latin American Debt Crisison the U.S. Economy a staff report of the Joint Economic Committeeof Congress, May 10, 19
86. Note: Due to its special situation, Continental Illinois wasleft out of these calculations 82) Reauire the U.S. ba nks to workout their own arranaements with Mexico.
The U.S. government has no.obligation to protect Americanbanks--or any other industry--from losses due to bad busines sdecisions. government of Mexico They have many options. For onething, the banks could extend new loans and roll over old ones. Foranother they could cut their interest rate spreads-the profitmargins on their loans--as any other industry would when it smarket contracts.
The banks also could consider a negotiated interest payment cap.For example, they could agree to accept interest payments of 25percent of Mexico's export earnings. .Combined with writedowns andreductions in overall outstanding princi pal, banks could stillprofit underfthis arrangement. While this latter option is theleast desirable choice and would set a bad precedent, it would beless disastrous than bankruptcy The banks should work out whateverdeal they can with the 3) Promote de bt/eauitv swans.
The Mexican government has shown wisdom in allowing foreignbusinesses to swap portions of Mexico's debt purchased fromcreditor banks for government equity in Mexican companies. The U.S.Commerce Department should alert interested U.S. bu sinesses ofthis possibility and provide them with the appropriate technicalinformation. U.S banks currently are prohibited from owning equityshares in any businesses, Mexican or American. Yet debt/equityswaps between the banks and the Mexicans would e a se further thedebt problem and probably fit in well with Mexican attempts toprivatize state-owned enterprises. Congress thus should amend theGlass-Steagall Act, which forbids equity ownership by banks, toenable U.S. banks to take possession of equity in Mexican companiesunder the debt/equity swap arrangement 4) Continue to encouraaeMexico to make market-oriented economic reforms.
The Mexican government is under intense internal pressure tostay with the failed socialist policies of the past. But withoutbasic reforms, easier IMF conditions and bank concessions. areworthless,.
The Reagan Administration therefore must continue to encouragereceptive Mexican leaders to make market-oriented reforms.
Mexicans are sensitive about foreign pressure, especially fromthe U.S., this encouragement should be discreet. Public criticismof Mexico is likely to be counterproductive and should beavoided.
U.S. also should ask the Western Europeans and Japan to tenderfree market suggestions Since the The 95) Exnlore further sDecialfree trade and investment arranuements.
The success of the maauiladora system is a base for furtherexpansion of free trade and investment. Currently, all finishedproducts from maauiladora factories must be re-exported to theU.S.
It wo uld be better if Mexico would allow some of these goods toenter the Mexican market. In exchange, the U.S. could cut furtherthe duties on the value of labor added to the products. Thepossibility of complete free trade and investment zones also shouldbe explored.
Ultimately, a complete Free Trade Area between the'U.S. andMexico should be sought, similar to the U.S.-Canada pact now beingnegotiated.
CONCLUSION Mexico's economic problems are extremely seriousWhile the oil price drop was the immediate cause of the currentdifficulties Mexico's own statist economic policies are at the rootof its problems.
Mexico. To the contrary are too high free enterprise principlesthat will restore its economy. Otherwise the U.S. will soon havefar more than merely a n economic problem on its southern borderBut this does not mean that the U.S. can turn its back on Theeconomic and security interests at stake The U.S. must encourageMexico to embrace the sound Edward L. Hudgins, Ph.D. a WalkerFellow in Economics 10 -
