Before the December 1994 devaluation, the Mexican government had essentially pegged the peso to the US dollar through its exchange rate stabilization program. Mexico permitted its exchange rate to fluctuate within a band of 2 percent. However, in December 1994 Mexico faced a balance-of-payments crisis. Investors lost confidence in Mexico's ability to maintain the exchange rate of the peso within its trading band, in part because of Mexico's large current-account deficit, which had reached almost $28 billion in that year. Intense pressure on the peso in foreign-exchange markets threatened to exhaust Mexico's international reserves. This pressure eventually compelled the Mexican government to float the peso and led to the now-famous peso crisis between December 1994 and early 1995.
Exchange rate stabilization programs by developing countries are very difficult to pursue effectively over protracted periods. In programs such as that of Mexico, devaluation is not unusual, even when care is taken to address the typical problems by using exchange rate pegging as only a part of the overall program. After taking office on December 1, 1988, President Carlos Salinas used "pegging" as an important element of a broader program that included reduced government spending, tax reform, deregulation, privatization, and significant trade liberalization - including rapid reductions in tariffs and quotas through entries into the General Agreement on Tariffs and Trade (GATT), into the North American Free Trade Agreement (NAFTA), and into the Organization for Economic Cooperation and Development (OECD). This broader economic program reduced the number of government-owned enterprises from 1,100 in 1987 to 220 in 1994, decreased inflation from 159 percent in 1987 to 7 percent in 1994, eliminated the nation's budget deficit, increased exports to the USA by 35 percent, and cut wage increases in half between 1987 and 1994. The real sector of the Mexican economy was healthy, not sick.
The key, then, was not to balance the current account with the rest of the world, but to balance trade deficits with voluntary investment inflows. Mexico ran current-account deficits of $25 billion in 1992 and $23 billion in 1993, and during this time not only maintained the peso at around $3.1, but accumulated large foreign reserves. In 1994, the current-account deficit was only slightly higher - $27 billion after 11 months. The problem came with the inflows, as political turmoil shook investor confidence.
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