The Plunger: the Peso Heads South

By Richard Lacayo

Not long after he took office last month, Mexico's new President, Ernesto Zedillo Ponce de Leon, received a note of congratulations. The sender was Subcommandant Marcos, the masked, green-eyed leader of last year's bloody rebel uprising in the remote southern highlands of Chiapas. What it said was not exactly cordial, but it was to the point: "Welcome to the nightmare."

If Zedillo wasn't sure how big his nightmares could be, he is now. So are millions of Mexican citizens, a good many battered international investors and the world at large. All it took was a few wild days of free fall by the Mexican peso, which hit the ground with a force that shattered some bright assumptions about the immediate future for what had seemed one of the most promising economies in the developing world.

After his Finance Minister said publicly just 10 days earlier that the currency would not be devalued, Zedillo used the occasion of a potential December uprising in Chiapas first to nudge the peso downward, then abruptly to let it float against the dollar. Plummet is what it did instead. In a world where international investment money can cross borders with a few taps on a computer keyboard, a thunder of key taps arose from the offices of stunned investment-fund managers in New York City and other financial centers. As they swiftly dumped Mexican securities, the peso went into a tailspin, at the worst point losing 40% of its value. Within nine days of the start of the crisis, as much as $8 billion -- 12% of Mexico's total foreign investment -- may have fled the country.

That represents a devastating loss for a nation that has been strongly dependent on funds from abroad to fuel its economic revival. Coaxing the money back will be a tough problem for Zedillo, but only one of many. Another will be how to keep interest rates high enough to attract new investors without sending them so high that they force Mexico into a recession. Commercial lending rates have already almost doubled since the devaluation, to hover around 40%. Credit-card rates are more than 50%. Yet another problem will be how to keep a lid on inflation, which the devaluation is sure to fuel. Perhaps the biggest will be to restore confidence in the fledgling presidency of Ernesto Zedillo.

For the U.S., which is tied to Mexico more closely than ever by NAFTA, it is important that Zedillo solve all of these problems. Mexico's long-term prospects still look good. But the peso mess raises questions about the ability of the nation's leaders to ensure the stability of Mexico, the U.S.'s second largest trading partner, where Americans hold more than half of all direct investment. Wary of appearing to be managing Mexico's affairs, the White House kept silent for most of last week, even as it worked overtime to arrange an international peso-rescue package of as much as $13 billion, including private bank loans and $7 billion in credits from the U.S. and < Canada. That's in addition to a $6 billion currency swap fund that the U.S. already had in place to bolster Mexico in any currency crunch. News of that deal helped the peso move back upward and halted the accompanying downward swoop of the Mexican stock market.

The peso's troubles are expected to have little direct impact on the U.S. As Mexican wages grow cheaper in dollar terms, some U.S. firms may find it more attractive to move jobs south. But Mexico may become less attractive for firms like auto manufacturers that would still have to bring in dollar-priced American-made parts for final assembly. "Mexican products will be more competitive on the global market, and there will be more jobs created in Mexico than otherwise would have been the case," says Robert Hormats, vice chairman of Goldman Sachs International. And the prospect of gradual improvement in the Mexican economy leads most analysts to discount the possibility that the peso's swoon will mean a sizable new surge of illegal immigrants pouring into the U.S.

The irony of the peso's misfortune is that it happened to a country that up until a year ago gave all the signs of being on a durable winning streak. Mexico has steadily climbed out of the debris of the debt crisis of the early 1980s, when a dip in the price of oil, its most valuable export, left the nation unable to pay its bills. For years afterward Mexico was a dirty word to foreign investors, who left it to starve for development capital. Rebuilding credibility required a long stretch of austerity and the sale of inefficient state operations like banks and telephone companies, measures begun by President Miguel de la Madrid and continued by his successor, Carlos Salinas de Gortari. Salinas got foreign-debt payments down to a fraction of the annual budget and performed the ultimate miracle of lowering Mexico's inflation rate from 157% to less than 10% by last year. By 1989 the gross domestic product was growing again in per capita terms. A debt-reduction agreement the next year started foreign money flowing back in, especially from the U.S. With the passage of NAFTA, which made Mexico's prospects brighter still, the money continued to pour in.

And also pour out. By the end of the Salinas years, an emerging middle class was gorging on imported automobiles, televisions and other luxuries. Between 1987 and 1993, while exports grew by roughly half, imports quadrupled. Meanwhile, Mexico's poor, perhaps 40% of the population, were still waiting % for the benefits of growth. On Jan. 1, 1994, the same day that NAFTA went into effect, some of the poorest began a 12-day uprising in the remote southern highlands of Chiapas. The government arrived at a shaky peace with the rebels, but it was just the start of a year that made investors further question Mexico's stability.

The worst shock was the March assassination of Luis Donaldo Colosio, the presidential candidate of the Institutional Revolutionary Party and Salinas' hand-picked successor. As a replacement, Salinas pressed the party's Old Guard to choose his Education Minister and Colosio's campaign manager, Zedillo, a Yale-educated technocrat. As a campaigner, Zedillo was so colorless that at one rally his wife had to nudge him to throw his arms into the air and shout "Viva Mexico!" at the appropriate moment. But he was committed to the Salinas reforms. Then in September came another blow: the killing of Zedillo's main political adviser, Jose Francisco Ruiz Massieu.

For all that, Zedillo came to office with the advantage of having won what was generally agreed to be the cleanest race in modern Mexican history. What he did not get was one crucial gift from Salinas. For months investors had been expecting that he would devalue the currency, a common favor that departing Mexican leaders perform as a sort of economic housecleaning for their successors.

To the surprise of many, Salinas left office instead with the peso still hovering at an unrealistic four to the dollar. Even without a devaluation, he reckoned, the underlying strengths of Mexico's economy would continue to draw investors, however nervous they might be about his nation's political stability. What he failed to calculate was the impact of rising interest rates around the world, especially in the U.S., which gave investors attractive alternatives for their money. Another possibility is that Salinas, who would very much like to be named the first head of the World Trade Organization, which will be created under GATT, didn't want to go out with any more blots on his resume.

Zedillo was convinced that he would have to undertake the devaluation himself when the Chiapas rebels launched a new offensive in advance of the first anniversary of their uprising. Within days the rebels had captured dozens of villages, disabled 47 jungle airstrips and seized several highways. On Dec. 19, Zedillo got the news from Finance Minister Jaime Serra Puche that the prospect of further trouble in Chiapas had prompted jittery Mexicans to move about $1 billion out of the country that day alone.

Though Serra had reassured investors just days earlier that the peso would remain stable, Zedillo directed him to blame a climate of insecurity spawned by the rebels for a change in policy. Within 24 hours the peso lost 12% of its value. Then came the bombshell. Despite an earlier promise of no further devaluations, Serra abruptly made public on a television show that the peso would be permitted to float against the dollar.

Serra, a highly confident technocrat who oversaw the NAFTA negotiations for Mexico, had misjudged the importance of hand holding in the world of high finance, especially when the hands control your country's fate. Money managers in the U.S. were stunned. During the Salinas era they had grown accustomed to being alerted in advance to any major change in Mexico's financial policies. In a reaction that reflected professional pique as much as considered judgment, they dumped Mexican securities as fast as they could.

When at last he flew to New York on Dec. 22 to face a meeting of angry bankers and fund managers, Serra found a roomful of sour expressions. To make matters worse, he lacked answers to many of the group's questions and bristled when asked why he hadn't resigned after having broken his promise to the financial community. "Everyone's been yelling and screaming all year for the peso to be devalued," says Kathleen Heaney, head of Latin American equity research at Bankers Trust. "But the way it was done really freaked people out. Wall Street doesn't like surprises. You get penalized when you do that."

After nine days of silence, which did nothing to reassure foreign money centers, Zedillo went on national television last Thursday to announce his acceptance of the international rescue package and to offer the very broad outlines of a plan to keep inflation down, continue to attract foreign investment and promote growth. Zedillo also announced the resignation of Serra, whose ambitions to be President someday spiraled down with the peso. As his new finance chief, Zedillo picked Guillermo Ortiz Martinez, a government economist well known to Wall Street, who had tried and failed last fall to get Salinas to approve a plan for an orderly devaluation of the peso.

Ortiz's first test will be to make sure his government meets interest payments on cetes, its peso-denominated short-term bills. To demonstrate that it means business about wooing investors again, Mexico almost doubled the interest rate on those bonds at auction last week, from 16% to 31%. Even so, there were few takers. A similar rate increase is contemplated for the tesobonos, securities with terms of three months to a year, which are held by foreigners in the billions of dollars. As another way to raise cash, Zedillo will sell off more state-owned enterprises, though the prize most sought after by outside investors, the petroleum monopoly PEMEX, remains off-limits to foreigners for the moment.

Even if it works, the rescue plan means a lot of pain for Mexico. "The middle class will lose its toys, and more," says Jorge Alonzo, managing director of Chase Manhattan in Mexico. "The poor will have to wait even longer for help. And investors will think twice about coming back to Mexico." Alonzo's time frame for recovery from the devaluation: "Two years of doing the right things and reassuring investors." Robert J. Polasky, director of Latin America Research at Morgan Stanley, agrees. "Those in bonds are saying they are not going back into Mexico any time soon."

However badly it was handled, the peso devaluation is widely regarded as a good thing for the Mexican economy. It will attack the trade deficit by raising the cost of imports while making Mexican products more competitively priced in world markets. "Without a doubt there will be an inflationary bubble," says one senior Mexican government official. "But we hope that it will be temporary. We think that a quick dose of strong medicine will get us back on track by the second half of next year."

This week Zedillo will unveil the details of his plan for bringing his suddenly bumptious economy in for a soft landing. One of his greatest challenges will be to diminish the impact of the devaluation on the purchasing power of Mexicans by getting the peso to a realistic value of between four and 4.5 to the dollar. Another problem will be how to sustain the pacto, a wage- and-price agreement among business, labor and government that was renewed by Salinas just before he left office. Because a cheaper peso means higher prices, labor leaders are threatening new wage demands, and the government has been forced to crack down on stores that have pushed prices above legal limits. Mexican officials say Zedillo is prepared to accept an inflation rate of 15%, although experts predict it may go as high as 20%.

As for Chiapas, for now Zedillo has some breathing room. Recognizing that he | had to defuse the situation quickly, last week he drew back an army buildup around rebel areas and accepted the rebel demand that Bishop Samuel Ruiz help negotiate peace. But in his new economic plan he is certain to defer his election promise that 1995 will be the year that prosperity will trickle down to the masses. That could mean the kind of social discontent that launched Mexico on its most recent cycle of headaches. Welcome to the nightmare.

CHART: NOT AVAILABLE

CREDIT: Bloomberg Business News

CAPTION: Losing Its Luster

Number of Pesos in a U.S. Dollar

With reporting by Laura Lopez and John Moody/Mexico City, Sribala Subramanian/New York