By Preston Keat
Investors are currently worried about the credit worthiness of a number of emerging market countries, and their fears have been compounded by the global economic slowdown and credit crunch. Argentina, Hungary, Pakistan, Ukraine, and Venezuela are among the most serious cases. Will these countries be able to implement policies that will change perceptions, or will they end up radically devaluing their currencies or defaulting on their sovereign debt?
Sovereign credit and currency risk models can give indications of what they "need" to do to avoid a market crisis. But they have little to say about what they actually "will" do. It is this "willingness" component that is typically driven by politics.
Politicians usually understand that certain policy choices may generate a market crisis -- market participants warn them about the implications of their actions frequently, after all. So in order to forecast whether a country will follow through with the right policy mix to avoid a crisis, it is essential to understand both the policy objectives and political constraints facing the politicians in charge.
The following is a classic case from Mexico, featured in "The Fat Tail," where political dynamics trumped economic logic, and led to an economic crisis with long lasting political implications:
In late 1994, Jaime Serra Puche, a rising star in Mexico's Institutional Revolutionary Party (PRI) and the country's newly appointed finance minister, was expected to manage a currency devaluation without stirring up political or economic trouble. The celebrated negotiator, famous for delivering on the North American Free Trade Agreement (NAFTA) failed on both counts. Mexico experienced a massive, rapid devaluation of its currency (the peso), which helped to strip the PRI of its dominant hold on Mexico's political landscape.
Forced to marry the PRI's political agenda with the demands of modern capital markets, Serra was probably doomed to fail, and he became a scapegoat for the "peso crisis." But the real story is about the PRI and its approach to maintaining single-party dominance.
That decades-long dominance is a testament to the power of graft and political patronage. The party was essentially run as a massive Tammany Hall organization, dispensing economic benefits to the leadership of different social groups, such as trade unions, state and agricultural employees, and regional party bosses. The Peruvian novelist Mario Vargas Llosa aptly called PRI's rule "the perfect dictatorship."
Yet the manipulation of economic policy for political gain would ultimately break the PRI's grip on power. Its inability to retire its patronage machine contributed substantially to the 1994 peso crisis and the party's first ever political defeat two years later. This crisis illustrates perfectly how political factors can trigger a financial crisis.
In the years preceding the 1994 currency collapse, the PRI's Carlos Salinas administration (1988-94) carried out ambitious market-oriented economic reforms that produced a significant reduction in inflation and the implementation of NAFTA. Before the crisis, Mexico's economy was in erasonable shape, although a growing account deficit would probably have eventually made a currency devaluation necessary.
Economics alone cannot explain the peso crisis. A devaluation could have been technically managed to ensure a soft landing. As one group of observers pointed out, the Mexican currency crisis was driven by poor political responses: "The state of illiquidity at the end of 1994 was due to unexpected shocks that occurred throughout the year, and the inadequate policy responses to those shocks."
Mexico was running a current account deficit, at least in part, because it was entering an election year. To maintain the PRI's grip on power prior to the August 1994 presidential elections, the government embarked on a plan to improve economic conditions. This had been standard PRI operating procedure for the previous 70 years: every six years, the party would increase public spending before an election to buy off key groups of voters.
The Salinas government launched the usual PRI spending spree, allowed cheap credit, and avoided making a much-needed correction in the exchange rate. It was no secret during early 1994, before the December peso devaluation, that Mexico would need to devalue its currency-markets expected it, and many investors headed for the exits to beat the rush. But a devaluation or a rise in Mexican interest rates before an election was a political poison pill the PRI was not prepared to swallow. Not in 1994. Not six years after Carlos Salinas had won by the narrowest of margins, possibly as a result of electoral fraud.
Patronage politics were compounded by a number of other unexpected political events that intervened to force the Mexican government to artificially stabilize the economy to win popular support. First, the left-wing Zapatista guerrilla uprising in the state of Chiapas frightened foreign investors. Three months later, the PRI's initial presidential candidate, Luis Donaldo Colosio, was killed in Mexico's first high-profile political assassination in decades. Ernesto Zedillo, an uncharismatic technocrat, took his place. Finally, a series of kidnappings of prominent businessmen further exacerbated investor anxiety. The government's decision to try to mitigate the political turbulence rather than tackle the economic situation with sound corrections to fiscal, monetary, and exchange rate policies made matters worse.
So during 1994, the PRI needed, more than ever, to use economic means to keep its political machine running. It was not prepared to do what markets were implicitly asking for: effect an orderly devaluation of the Mexican currency and rein in spending. By keeping the peso strong and public spending high, essential voter blocs and interest groups were kept on the PRI's side. This strategy proved politically successful. In December 1994, Zedillo was elected president of Mexico. But economically, the PRI created a time bomb with a very short fuse. During the same month Zedillo was elected, Mexico finally decided to devalue its currency. Zedillo devalued the peso by 15%, to 4 pesos per dollar. This was too little and too late: the devaluation resulted in widespread market panic. The peso promptly went fell from 4 pesos to over 5.5 pesos per dollar and continued to weaken through the winter, reaching a low of 7.45 in March. This triggered the worst economic crisis in Mexico in half a century. It also raised concerns about a potential Mexican default on its sovereign debt, which was only averted through prompt intervention by the IMF and the U.S. government. They combined to stabilize the peso with a $50 billion bailout.
The "December mistake," as the crisis came to be known, also severely weakened Zedillo's political standing. Zedillo found himself caught between the need to legitimize his presidency by making concessions to the opposition to gain approval for his costly stabilization plan and the PRI's hard-line stance that he should make no economic or political concessions. Zedillo was forced to sacrifice party approval for the sake of the economy, and in 1996 he implemented an electoral reform that proved to be a significant step toward political liberalization. The next year, the PRI lost its absolute majority in the lower house of congress for the first time since it was created. It was the beginning of the end for the PRI's one-party rule: in 2000 an opposition presidential candidate (Vicente Fox) was elected for the first time in 71 years.
The most interesting angle to this story is how political logic and interests trumped economic rationality. Economists often assume that governments will choose to implement sound economic policies. The peso crisis was not a bolt from the blue in political terms. Economists knew the peso was overvalued; some notable ones had been advising a devaluation of the currency well before the crisis. Capital markets had also noticed the Mexican budgetary and currency imbalances, and foreign capital was leaving the country. However, what economic analysis did not capture is that the PRI could not devalue the peso, for political reasons. Ultimately, the pain and the cost that the Mexican economy and its people had to bear as the result of the devaluation were the price that the PRI had to pay for the continuation of its rule. Only by understanding the nature of the country's (or party's) specific political constraints does that become obvious.
Excerpt reprinted with permission from The Fat Tail: The Power of Political Knowledge for Strategic Investing published by Oxford University Press. Copyright © 2009 by Oxford University Press, Inc.