PERSPECTIVE ON MEXICO : Investors With Cold Feet Were Too Quick to Run : The government’s old high-risk strategy should have been adjusted slowly, but the pressure was beyond its control.

To describe the Mexican government’s decision to let the peso float as an “act of betrayal” is plain wrong. No minister of finance in his right mind would produce an unexpected and undesired devaluation on purpose when the country is on the verge of obtaining an investment rating. No government would choose to risk the country’s credibility, won by many years of sacrifice and austerity.

Letting the peso float was a necessary response to the changing realities of the market. Investors, domestic and foreign alike, were fleeing the peso in leaps and bounds and the country’s international reserves would soon disappear.

True, the handling of the decision and how it was communicated to the public reflected a degree of unpreparedness unexpected of a team that has been in government for about 12 years and witnessed several exchange-rate crises in the past. But surely no one can believe that the problem began Dec. 1, when President Ernesto Zedillo took office. Outgoing President Carlos Salinas de Gortari left his successor with two unsolved and complicated problems: the uprising in Chiapas and a huge current= account deficit. The latter, which equaled $28 billion in 1994 and was estimated to reach $30 billion in 1995, was the result of a policy that used the exchange rate to fight inflation at the expense of competitiveness and growth.

Fixing the value of the peso or its daily depreciation, what economists call a “crawling peg,” coupled with fiscal discipline, succeeded in bringing inflation down from three digits in the mid-1980s to the single-digit level. Curbing inflation was not a minor achievement and its social payoff should not be underestimated. However, after a while, the price paid for this policy was rising disequilibrium in the trade balance as an appreciating peso made imports cheap and exports less competitive. It was expected that the gap would eventually disappear as the modernization of Mexico resulted in higher levels of productivity and domestic savings. In the meantime, the presumption was that the gap would be filled by capital inflows attracted by Mexico’s high returns and long-term economic prospects. The problem was that as investors saw the external trade gap continuing to grow and the domestic political situation becoming more unstable, they demanded higher “risk premiums” on their returns. Higher interest rates, however, were incompatible with economic growth. Lower inflation and higher growth became incompatible, and as the government tried to pursue both in 1994, investors’ confidence eroded and capital flight followed.

With hindsight--and as several analysts had suggested at different points in time--it would have been wise to change the exchange-rate policy by raising the ceiling of the band within which the dollar fluctuated or increasing the “crawl,” maybe as early as 1993. The serious mistake was to keep the same policy through 1994, a year of rising interest rates in the United States and unease in Mexico as a result of Chiapas and political assassinations.

Under those circumstances, to rely on foreign investment to bridge the gap was a high-risk strategy. Portfolio investment can leave the country overnight and bring it to its knees, and Mexico got dangerously close to this. Increasingly, the sustainability of the strategy depended on the few wealthiest men in Mexico and on Wall Street’s confidence. Whether the huge trade deficit was a temporary phenomenon, as Mexican policy-makers argued, became irrelevant. Investors’ patience came to an end before we could find out.

Given the high risk, why did the new administration continue to support the strategy? Why risk becoming the pariah of international investors scarcely three weeks after taking office? Clearly because changing the exchange-rate regime could never be done without a serious blow both to credibility and the short-run performance of the Mexican economy.

A devaluation will inevitably be followed by higher inflation rates and a slowdown in economic activity in the short run. How sharp both will be depends on the accompanying measures and the reaction of the public. The larger the devaluation’s impact on prices, the more the government will need to cut public spending and curtail the money supply, and the sharper the economic slowdown.

However, Mexico’s economic future is much brighter than what current circumstances augur. As so many analysts have repeatedly said, today’s Mexico is a different country from the Mexico of 12 years ago.

In 1982, the public sector had a deficit equal to 16% of the country’s product, 100% of imports were subject to licensing, and the banking system was nationalized. Today, public finances are in order, the Mexican economy is open to world competition and Mexico is a member of the North American Free Trade Agreement.

In 1982, more than 40 years of import-substitution industrialization had given Mexican entrepreneurs little experience to compete in the foreign markets; now, after six years of an open trade regime, Mexicans have learned to export and should be in a much better position to profit from the advantages provided by a more expensive dollar.

If the government makes the appropriate policy choices--a tight fiscal and monetary policy, cost-lowering deregulation and confidence-building measures--the inevitable pain of the next few months will be followed by a gradual and sustainable recovery.

One should never underestimate the ability of countries to get back on their feet after a crisis. As people should never have been so optimistic about Mexico in the past, they should not be so pessimistic in the present.