Agency Conflict and the Signalling Snafu in the Mexican Peso Crisis of 1994

This paper analyzes the Mexican peso crisis of 1994 in terms of false government signals and the agency conflict that pits national governments against international lenders when national governments have the power to use moratoriums, repudiation, or default to subordinate the claims of international lenders to those of domestic agents. The term international lenders includes domestic residents with the capacity to invest abroad. In a first step, the paper presents evidence to support the conventional conclusion that Mexico's underlying economic and financial situation did not warrant the humiliating treatment inflicted on it by the international financial markets. In a second step, it examines the hypothesis that the behavior of the international financial markets was the result of a mindless overreaction to suddenly perceived changes in the country's political fragility and shows that this was not the case. On the contrary, it is shown that the markets recognized the country's evolving political fragility and compensated for it as far back as 1991. In the third step, the paper analyzes the hypothesis that the Mexican peso crisis of 1994 was the result of false government signals and a rational reevaluation of the costs of the agency conflict that is inherent in the relationship between national governments and international lenders. Using standard methods in stochastic calculus, the agency conflict is modeled as a government held option to default. Applying this model, the effects of false government signals concerning the country's economic and financial situation are then measured. The results are consistent with the hypothesis that the agency costs were reevaluated when it became clear that the Mexican government had been sending false signals to the international investment community and that these false signals had made it possible for Mexico to borrow close to or beyond the point where default was the optimal financial strategy