ACME CASE and Mexico Crisis

1. 
The financial crisis that followed the devaluation of peso in December, 1994 was a complete shock for observers. Despite of the earlier predictions that had been saying that the peso was overvalued what happened after the Mexican government devaluated the peso by 15 % to dollar (up to 4 pesos per US dollar) was an unexpected event. 
With the evident complexity to predict that course of events, however there were warning signals that taken into account would not catch Mr. David Louis by surprise, as the Tequila Crisis was a reasonable result of a combination of economic and political factors. 
Political and economic situation and changes is Mexico has been showing a traditionally high correlation, and economic cycles were highly affected by the events in political sphere. Pre-electoral fiscal and monetary policies as 1994 was the last year of 6-year administration of Carlos Salinas were marked by the large spending splurge and higher deficit. The armed rebellion in Chiapas and assassination of several political leaders led the sovereign rating down. 
The imbalances in macroeconomic situation, if corrected in a timely manner could prevent the crisis, were widely available to both foreign and domestic managers and investors. 
1) Fixed exchange rate system. The pegged exchange rate besides from the possibility of creating the speculative attacks had a negative impact on demand of domestic tradable goods; inflation rates were higher than in US; and overvalued peso was shrinking foreign exchange reserves.
2) Lax banking practices and supervision. In fact, the familiarity between borrowers and banks was leading to poor monitoring and credit decisions based on not reliable financial information, shifting banks’ portfolio away from safe borrowers to borrowers which didn’t have dollar revenues, hence creating a significant credit risk for these banks;
3) Tesobonos issue. The shift from long-term fiscal policy to a short-term resulted in a current account deficit, as the maturing Tesobonos could not have been repaid if any devaluation occurred. Between March and June, 1994 the price of Tesobonos increased from USD 4,1 billion to UDS 12,99 billion, reaching the figure of USD 21,55 billion in December, pulling the Bank of Mexico to further exchange risk and dwindling international reserves
4) Enormous privatization and liberalization. Week governmental regulation and lack of governmental interference and elimination of basic governmental functions (as social order, assuring law) failed to prevent the commercial banks from risk accumulating uneconomic loans on their balance sheets, a move that contributed to the crisis. 
5) A substantial rise in US interest rates. Developing countries have an unpredictable and sharp reaction towards what is happening in the international markets and raise in interest rates affected net capital flows to Mexico drastically. 
6) The excess of private investment over savings was also a source of vulnerability, and combined with growing trade deficit, peso’ appreciation and undue rely on portfolio investments that are more volatile in response to perceived risk were leading to the balance of payment crisis. 
The decision of Mr. David Louis to change a job is quite risky because the instable situation and high-rate unemployment were expanding and this probably was not the best way out, but he should be more worried of the ongoing situation and paying more precise attention to the economic signals and work out a safe strategy.

2.
Since the crisis in 1982 the Mexican Government was aiming at inflation reduction primarily and was not paying due attention to the real exchange rate between dollar and peso. Despite of the fact, that the exchange rate regime had undertaken several modifications, the real appreciation of the local currency existed and simultaneously the inflation rate was higher than targeted. Over time, the inflation was cut dramatically, but the appreciation of peso was encouraging imports and expanding the current account deficit, a danger that Mexico’s policymakers were not unaware of. 
At the same time, Mexico was attracting the huge capital inflows as a developing country with high interest rates. The problem that dominated here is that foreign capital was not spent on new equipment, factories or plants – at least, directly and miserably small portion. The largest portion of all foreign investments took form of short-term financial investments. Governmental bonds, as well as purchase of other bonds and stock, was the main instrument of attraction of investments, that, on the one hand, contributed to the country’s capital account, and on the other hand, was simple to pull out; however the government was putting itself in a danger and in a tremendous pressure if any financial risk or crisis arose. A combination of Mexico’s quasi-pegged exchange rate, overvalued peso that needed urgent corrections and lack of capital control also was a matter of pressure on reserve holdings, mistaken governmental policy. 
Moreover, a switch to Tesobonos that introduced a potential cost and a risk transfer from investors to the Mexican government, Central Bank’s need for an autonomy and release from political influence, the Central Bank’s fail to persuade tight monetary policy and increase interest rates substantially during 1994, and a considerable delay in the changing of non-flexible exchange rate regime, over-reliance on non-domestic savings, fiscal policy and tax collection regulation that were ineffective, hostile and unregulated privatization and liberalization, primarily in banking sphere – were the basic errors and challenges for the Mexican government. 
Perhaps, to avoid the crisis of 1994 or to some extent to eliminate it several steps towards alternative policy could have been implemented by the government. Among the main ones that are highly arguable and carry another unattractive risks are:
— An earlier decision to float the peso. This reasonably could have been the least painful method if applied in 1992s in accordance to European governments that suffered speculations because of the fixed exchange regimes. But any structural changes were dangerous to the “Pacto” and thus were avoided by the government, with regard to the desire of the political leaders to protect their reputation and popularity with stable peso and low inflation. To some extent, the government was persuaded by the business to continue with the band approach. 
— Impact and encouragement of direct investment, ahead of portfolio ones. The Government failed to realize this because of its over confidence in future maintenance of capital flows, undue optimism about country’ attractiveness to foreign investors, based on recent success and implementation of NAFTA.
— Plan of measures prior to the December 20 devaluation. This possibly could include the widening of the exchange rate band, increase of daily depreciation of the ceiling. Also assumed by the Government that the growing current account deficit was temporary and would come down as capital flows would finance deficit, the same nominal exchange rate policy was followed. Additionally, the measure to increase the domestic savings via fiscal policy was overlooked by the officials. 
— Correct handling of the crisis. Options could include 1) reinforcing of the existing exchange rate, introduction of higher interest rates, tightening of the monetary policy, ending the policy of sterilizing reserve losses, hence slowing economy; 2) abandoning of the exchange rate peg, connected with the treat that peso will sharply decline because of the previous commitment of the government to maintain the peso’s value, and the government were not eager to shaken public confidence; 3) a switch to currency board, by government didn’t’ apply this partly because this wouldn’t eliminate the crisis and prevent private entities from getting into illiquid position.

3. 
Given the certain political environment in Mexico and taking into account the macroeconomic factors in the county’s development Acme was put in the tight position during these years (however, the Company better reserved money in advance to compensate some risks from the reserve fund), and before the financial crisis 1994 several steps could have been undertaken in order to defend the company and maintain strong position. Since Mexico’s sharp devaluation was a surprise for companies and they didn’t’ predict that course of events the options proposed can be followed to mitigate risk associated with doing business in a developing country with obvious economic circles and a possibility of getting into a crisis at least every 6-8 years connected with the start up of new administration. 
Firstly, an underdeveloped portfolio of financial instruments means that companies and investors do not have access to enough derivatives to mitigate risk. In this case, for Acme Toy Corporation the presence of long-term future or forward contracts in order to hedge position, as peso was devaluating first slightly, then sharply, was a rescue from the existing triggering situation, and since most payables were in US dollars and future contracts denominated in US dollars were removing the foreign exchange rate risk, existed in emerging markets such as Mexico. The raised expenses associated with hedging costs were able to provide some support for the company, simultaneously removing the systematic risk of investing in emerging market stocks. 
Secondly, operating in hard currency, such is USD, and accumulating dollar-denominated assets was at that time less risky, however, the Company was sure to lose the gain of getting higher percent rates if holding deposits in American banks. Sixty percent of short-term financial assets invested in Tesobonos, and last 40% in Banca Serfin created the dependence on governmental regulation, country risk-premium and any changes in the political structure. As seen later, not all Tesobonos were paid in full. Again, receiving less interest rate, some part could have been transferred to American Treasure Bills, or to riskier securities as the interest rates in the USA were rising, or a strategy to buy long/medium – term Mexican Governmental bonds with several-years expiration and buy credit swaps for 1 year, for most riskier years (such as elections). Similarly, they can use the interest rate swap market to manage the maturity structure of their external debt.
As the Company was holding P73 million export liabilities in foreign currency (vs. P 24 million domestic accounts payable) it could have been a right move to reduce payables in USD by revising contracts and switching to pesos, or at least including options of pesos acceptance. Additionally, the search for Mexican suppliers instead of foreign ones and a possible switch to them in order to have pesos payables and maintain dollars receivables was an alternative to eliminate increased direct costs. Associated expenses here are the switching costs, transaction costs and possible quality loss, if substitutional producers in Mexico found.
Moreover, the increase of the Acme USA equity share instead of taking an additional loan in US dollars would contribute to the Company’s dollar assets. Also acceleration of peso receivables from Mexican customers and delay in payments to Mexican suppliers resulted in a huge short-term financial assets that if left so would be depreciated largely after the events in December, 1994. Possibly, Acme Mexico could continue the payments in normal regime to support steady cash flows to/from the Company. 
However, multinational companies and Maquiladora industry were not seriously hurt by financial crisis, because most transactions were done in dollars, expect some domestic supplies and labor costs, Acme had to protect itself to continue to expand and not suffer losses.

4.
After the peso devaluation and during the following financial crisis many companies found themselves in a bankrupt position. These were primarily small and medium-sized companies which business was oriented towards domestic market. Nevertheless, maquiladora industry was quite beneficial and was viewed to continue to be so, as long as the present conditions were supported. The main obstacles of maquiladora companies, among which was Acme Toy Corporation, were the dependence on Mexican workers, who can anytime claim for higher salaries, conditions for capital and generated surplus-value. 
Temporary decision could also be made to stop/slow down all unprofitable operations and close businesses that were not accumulating profits, but were either cross-subsidized, or aimed at the long-run occupancy. 
Basically, the first step for Acme can be the business plan that analyzes the company’s dependence on Mexican supplier and buyers. As long as approximately two-thirds of production was sold to the USA, the company enjoyed favorable export conditions, labor costs were lower than in America the possible way out could be for Acme de Mexico to become totally export-oriented. Benefits of leaving the company in Mexico among others are 1) cheap labor; 2) already existed plants and equipment (74,8% of total assets); 3) domestic suppliers who are suffering losses too; 4) the possibility of application of 0% VAT; 4) to operate under Transfer Pricing principles and the concept of non – Permanent Establishment to avoid double taxation that came into force after events of December 1994; 5) sales into domestic market are also possible; 6) elimination of import duties on products manufactured or assembled in the maquiladoras upon importation into the United States or Canada, provided those products satisfy the NAFTA rules of origin. Evidently, that measures to save the company and to continue its operations instead of the closure or the plants allocation to another country are more beneficial, and since maquiladora industry enjoys a preferential regime these advantages should be used in full after the crisis to allow the company to recover. 
Concerning Mexican supplier there a risk exists that after small or medium-sized companies (supplier) went bankrupt these that survived would potentially become monopolists or capture the biggest market share leading to the price increase so that local supply would become economically disadvantageous and Acme de Mexico as mentioned above should be ready to find alternative, even possibly foreign suppliers for a variety of miscellaneous parts.
Additionally, not to borrow from banks and financial institutions in Mexico at the after crisis period seems to be a short-term measure that can save company from linking itself more heavily with domestic situation. To deal with the Mexican debts Acme can possibly sell its equity stake to Acme USA that would increase the capital and help to prevent the company’s illiquidity (risk of insolvency). As the outcome on interest-bearing deposits is likely to be diminished the company will find a lack of cash and short-term liquid assets and the capital inflow in US dollar will manage this problem and make it possible to deal with indebtedness. For a new US-owned company a maquiladora toy plant will help to remain competitiveness over Asian producers and allow low transportation costs due to the close proximity of Mexico. The only disadvantage for Acme de Mexico now is that the equity sale to US partners will be at very low rates. 
As long as many Mexican companies were hurt by the crisis and many of them were holding dollar- and peso-denominated debts the currency swaps between such companies to get interest gains could be used.
More likely, that maquiladora industry would be the main source of foreign exchange in the nearest future for the collapsed Mexican banking system and compile the big share in country’s GDP, so that the government will try to conduct a policy of favorable regulations and encouragement to maquiladora companies, such as Acme de Mexico and it’s important to be able to benefit from the current situation.

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