Watching the Peso, Waiting for Bargains : Crisis: Doubling of key short-term rate seen as strong signal that government is serious about retaining foreign capital.

The Mexican government on Wednesday doubled a key short-term interest rate in a drastic bid to retain foreign investors, amid reports that the embattled nation has lost $8 billion in capital since its financial crisis erupted last week.

The higher rate--along with reports that Mexico was negotiating with U.S. Treasury officials for emergency loans of up to $10 billion to quell the crisis--helped the peso on Wednesday regain some of the value it had lost since its devaluation sparked the crisis nine days ago.

The capital flight, equal to more than 12% of foreign investment in Mexico’s financial system, could lead to inflation as high as 20% and plunge the Mexican economy into recession, economists said. The continued loss of foreign capital could also require the government to adopt strict slow-growth measures next year at a time when Mexican consumers were expecting a respite from six years of austerity.

To stem the capital outflow, the Mexican government on Wednesday raised interest rate yields on 28-day cetes, Mexican government bonds roughly equivalent to short-term U.S. Treasury bills. The rate was hiked by 15 percentage points at the weekly government auction to 31%, the highest level in nearly five years.

The rate hike was interpreted as a strong signal that the government is willing to go to great lengths to attract and keep foreign capital. More than half the cetes in past auctions have been bought by foreigners.

The peso closed Wednesday about 4.9750 to the dollar, an almost 10% gain from its 5.50 close late Tuesday, although it is still down more than 30% since Dec. 19.

Mexican stocks and bonds also rallied amid reports of the possible emergency credit. Mexico’s benchmark Bolsa index rose 60.82 points, or 2.67%, to close at 2,337.72 on Wednesday, and some individual stocks made huge gains.

The peso’s partial recovery had been predicted by some who thought sellers overreacted to the Mexican government’s announcement last week that it would allow the peso to float freely in value against the dollar. John Williamson, a fellow at the Institute for International Economics, predicted Wednesday that the peso could bounce back to as low as 4 per dollar.

But the capital flight report and the spike in interest rates were ominous signs, and they raised fears of a replay of the 1982 peso devaluation, when a sinking currency, sharply rising interest rates and spiraling inflation caused a wholesale exodus of capital from Mexico to offshore havens.

The short-term practical effect of capital flight and loss of foreign investor confidence is an unstable currency: The Mexican government has diminished foreign reserves at its disposal to try to prop up the peso.

Higher interest rates carry risks. The yields ultimately will be reflected in bank loans and passed on to Mexican consumers and businesses. By increasing the costs of many products and services, sustained high rates initially will create intense inflationary pressure, said Mauro Leos, vice president of operation at Ciemex/Wefa, a Philadelphia think tank that tracks foreign capital in and out of Mexico. High rates later could slow the economy by inhibiting spending and prompting people to save instead of spend.

Investors are awaiting an economic plan to be released Monday by new President Ernesto Zedillo, who has been blamed for badly bungling the first Mexican devaluation in seven years.

The flight of $8 billion from Mexico’s financial system since early last week was estimated by Ciemex/Wefa and corroborated by Carlos Zarazaga, a senior economist at the Dallas branch of the Federal Reserve Bank. He said the outflow was equal to the amount of all new foreign investment that came into Mexico during 1994, thus wiping out any net gain.

The drain was caused by foreigners and Mexicans selling stocks and bonds and exchanging the peso proceeds for dollars, Leos said. The drain, combined with what the Mexican government has spent in recent months to defend its peso, has left the country with less than $6 billion in foreign reserves, down from $28 billion in March, he said.

The dramatic reduction in the Mexican government’s reserves is what is spurring its efforts to arrange a credit line with the United States, Canada and the International Monetary Fund. The credit would give Mexico the resources it needs to begin defending and staking out a value for the peso, Leos said.

The dwindling of foreign reserves was a principal reason for the devaluation. The government was also motivated by a desire to reverse its growing balance of payments deficit. By devaluing its currency, Mexico makes its goods more attractive on the international market.

Other side effects of shrinking foreign investment--in a country that relies on foreign capital as heavily as Mexico does--include a shrinkage in the money supply, a drop-off in spending by consumers and rising unemployment. Less capital means higher interest rates on loans taken out by credit-hungry borrowers, Zarazaga said.

Capital flight “is extremely serious,” Leos said. “It leaves the central bank with no power to influence the foreign exchange markets. It creates uncertainty in the outlook for economy in general because of the unstable currency.

“So, we have a crisis not only in that the currency is devalued but also because of the uncertainty about what the reference level is.”

To stabilize things, he said, Mexico urgently needs a credit agreement with U.S., Canadian and international funding sources, because Mexico “doesn’t have the internal resources to (defend its currency) on its own.”

Even after measures are taken, Mexico’s leaders will have a tough task restoring trust among foreign investors--and Mexican citizens.

“A lot of people thought things like this were not supposed to happen, now that Mexico was part of NAFTA and after the sacrifices that were done in the last six to 10 years,” Leos said.