Banks are Key to Full Mexican Recovery

Summary of working paper 7042
Featured in print Digest's possible to recover quickly from a major currency crisis, problems in the banking system must be 'fixed' if recovery is to be broad and sustained.

Mexico's quick emergence from the currency crisis of1995 is widely viewed as an impressive achievement, both for the country's policymakers and for the international effort that helped Mexico. Rather than resort to protectionism, as in the 1982 debt crisis, Mexico's leaders decided to stick with ongoing trade and economic reforms, while the United States, Canada, and several international institutions offered a vote of confidence in the form of a $52 billion line of credit. Ultimately, Mexico was able to take advantage of its sharply depreciated real exchange rate to greatly increase exports, creating a surge in trade credited with curtailing a recession. The government was also able to reduce inflation rapidly.

But according to Anne Krueger and Aaron Tornell writing in The Role of Bank Restructuring in Recovering from Crises: Mexico 1995-1998 (NBER Working Paper No. 7042), the crisis management strategy did not adequately address the fact that Mexican banks ended up with a lot of bad loans on their balance sheets, and the defaults continue to pile up, despite the overall recovery. They observe that, because of deteriorating banking conditions, Mexico's admirable comeback is also one in which the rising tide does not lift all boats.

In fact, the authors note that outside of the export sector, Mexican businesses have recuperated "sluggishly." Some key domesticate-oriented sectors have yet to reach pre-crisis production levels, a situation Krueger and Tornell link to a credit crunch in which struggling banks have little to lend, and what they do have is available only at very high interest rates.

Ironically, the credit crunch may be linked, to some degree, to the success enjoyed by export-oriented industries. Krueger and Tornell note that mining, manufacturing, and other booming trade-focused businesses are doing so well that they routinely bypass Mexican banks and secure capital directly from international financial markets, or from "upstream" partners, all of whom offer much better terms than domestic lenders. That deprives domestic banks of a significant pool of "high quality" patrons who have good credit ratings internationally and whose borrowing would strengthen the quality of the Mexican banks' portfolios. Then banks would be able to provide more money--at better rates--to creditworthy "non-tradable" (that is, firms that sell primarily in the domestic market) firms, such as those in services, construction, and commerce.

According to Krueger and Tornell, some banks are now making matters worse by engaging in risky schemes, as they seek a sudden reversal of fortune in the form of a big payback if the projects are -- against the odds - successful . But, predictably, they just end up creating more bad loans. Krueger and Tornell report that in 1997, the ratio of nonperforming loans to total loans at commercial banks in Mexico was 30 percent. This does not include bad debt already transferred to the Central Bank.

Krueger and Tornell believe there were good reasons Mexico did not deal forthrightly with the banking crisis during the1995 peso pummeling. In 1995, restoring investor confidence was paramount, and suddenly writing off a giant portfolio of bad loans would have been like trying to put out fire with gasoline. But the authors believe the country today has an economic and political environment sufficiently stable to permit a comprehensive bank overhaul and the imposition of new regulations without major upheaval. They note that, in some ways, Mexico has had "the misfortune of being lucky," with the export surge having "eliminated the immediacy of the crisis and the necessity to fix the banking problem."

A key lesson here, the authors state, is that while, given the proper conditions, it's possible to recover quickly from a major currency crisis, problems in the banking system must be "fixed" if recovery is to be broad and sustained. "Despite Mexico's impressive recovery, the data speak for themselves," the authors conclude. "The small and nontradable firms have recovered only sluggishly and are starved for credit."

-- Matthew Davis