A precise definition of populism is difficult to pin down. It's taken many guises in Latin America—authoritarian and intolerant in Brazil under President Getúlio Vargas, but more democratic and moderate in Peru's political experiments. However, the underlying ethos is essentially the same. Edwin Williamson, author of The Penguin History of Latin America, describes it well:

As Williamson alludes, populism is about people—the word itself is derived from the Latin word populus, meaning precisely that. Both politically and economically, populism has come to mean policies driven by and for "the people," and populist episodes often arise with the disaffection of a group and their desire to reclaim some form of "ownership" over society and government.

This estrangement is a recurring theme in Latin American history. The region has long suffered from inequality. The second half of the nineteenth century saw the rise of a powerful export oligarchy. They were capitalists only in the sense that they looked to profit from selling goods into the market. But they prospered largely from their political connections and monopolistic stranglehold on industry. Their success meant a small group of elites held a high concentration of income and assets. The sharp class and sectoral divisions developed between these wealthy asset holders and the lower-middle class workers can still be felt today. By one measure of income inequality—the Gini coefficient—Latin America remains the world's most unequal region.^[61]

Populism represented a natural alternative to this oligarchic past—a voice for the common man long suppressed by vested interests. In modern times, politicians have shrewdly catered to the alienated lower class to attain political power, leading to a number of key policies with profound implications for investors.

Later in the chapter, we provide an illustration of populism in practice under Brazilian president José Sarney in the mid- to late 1980s. Sarney's populist bent was one reason for the country's slow recovery from the 1982 debt crisis. But first, we summarize some of the most impactful legacies for investors from this political model, as these transcend any particular populist episode.

All democratic governments are to some degree beholden to the groups that provide their electoral victory. For Latin America's populists, that was the increasingly disenchanted and disadvantaged lower class. Progress largely bypassed this segment of society, and to win their support, politicians offered promises of monetary handouts and concessions. In practice, this translated to profligate fiscal spending on welfare and social initiatives—often beyond the revenue means of the government (i.e., deficit spending). Effectively, the government takes the economy on its shoulders and spends its way to growth.

Most populist governments are able to stimulate expansion for a short period of time with such policy. But eventually the government must source additional funds to continue supporting fiscal spending, since cutting these policies is political suicide. This uncovers two key themes found throughout Latin American history: high levels of monetary growth and a long-running love affair with debt and foreign capital. Both contribute substantially to the instability often associated with Latin American populist regimes.

Undisciplined fiscal spending often leads populist governments to hijack the money printing press, and the ensuing excessive monetary growth in turn creates inflationary pressures. Why is this so? As the famous US economist Milton Friedman once said: "Inflation is always and everywhere a monetary phenomenon."^[62] This means inflation is a function of liquidity—money supply—relative to the real economic demand for money. When money creation is in excess of total output growth, it invariably leads to inflation.

We can see this clearly in Latin America's history. The political concessions and handouts associated with populist regimes meant money was not always flowing through to the most productive economic hands. Total output growth was often substantially less than the growth of money, creating excess liquidity. And, more consistently than any other region in the world, Latin America has been afflicted by the scourge of inflation. Brazil represents one of the most egregious examples. Between 1980 and 1994, inflation increased an average of more than 100 percent per year. Put another way, prices increased by a total of 166 billion percent over the course of those 15 years.^[63] That's an unfathomably large number.

Inflation approaching such levels is called hyperinflation. But it doesn't have to get even nearly that far to incite instability. High inflation causes real incomes to decline, reducing consumption power. Lenders are also penalized because the real amount borrowers repay is less, hindering investment. For stocks, it reduces the present value of future earnings. If unchecked long enough, the decline in real incomes can become substantial enough to foster social unrest as the price of staple goods reaches stratospheric levels. The devastation of hyperinflationary periods is evident throughout history—from Germany's Weimar republic in the 1920s to Zimbabwe today.

Too-high inflation also distorts important price signals between producers, businesses, and consumers. A higher price for a pencil, to borrow from Friedman again, usually indicates people want more of it and that more resources should be employed to produce and meet the increase in demand. But in times of high inflation, companies may mistake the increased price of the pencil for an increase in demand when it really is a function of the inflation-related adjustments to prices (or vice versa). As you can imagine, a well-run business would likely slow production in the face of such uncertainty—it doesn't want to produce more of a product people don't want. Eventually, this leads to shortages.

A little inflation is a good thing, however. In fact, the worst possible price environment is one of declining prices, or deflation, where nominal wages and profits fall while the real debt burden increases. Borrowers are thus forced to reduce spending or, even worse, default. If you still think falling prices is a good thing, look at Japan's economic stagnation throughout the 1990s.

Markets are inextricably linked to political models. And political models are as varied as the cultures and people governed by them—democracy, authoritarianism, communism, populism, socialism, pick an -ism! Politics, through legislation, regulation, or even diktat, set the rules of the game. This is crucially important to investors—these models play a large role in determining winners and losers.

Depending on your -ism, the rules of the game can be substantially different. For instance, economic policies under Latin America's populist states benefited the lower-middle class (at least at first), and wealthy asset holders were the losers. By contrast, the winners in a democratic state are individuals motivated enough to compete for such status. Here, individual liberty generally sets people free to find their own success. Thus, while politics may enforce the rules, the model itself is equally critical—it determines what the rules are.

These rules also mean different things to different actors in the economy. The local butcher providing you with Sunday's pot roast will be affected by the political framework quite differently than the electric utility company supplying the power to the light you may be using to read this book. For example, in the US, the Food and Drug Administration has little impact on the profitability of your local utility company, but it clearly governs the actions of the butcher.

It's through this framework investors should evaluate the relationship between markets and politics. In Latin America, both directly and indirectly, the government's populist policies rested on wealth redistribution. Appeasing the masses meant taking from the "haves" and giving to the "have-nots." This included redistributing land, subsidizing prices for select consumer goods and companies, or subsidizing incomes, among others. Winners and losers were determined not by market forces, but by the motivations of the populist politicians.

Markets generally abhor forced redistributive policies. Basic property rights, protections, and contract enforcement are critical to the proper functioning of markets. Consider a simple example: A local drug company spends several years developing a drug that shows promising signs of reversing Alzheimer's disease. It spent several hundred million dollars on the drug's development, knowing it has a superb chance of being a blockbuster when it reaches the market. In the US, such an investment would be protected under patent law. But what if there were no such protection? Think the drug company would still expend such time and money on its development? Not on your life. Markets—and their profit opportunities—drive economic innovations and progress. Redistributive policy stifles this by injecting uncertainty and disincentives to take on risk for potential profit.

Last, from a broader perspective, many of the policies inherent in populist regimes—undisciplined fiscal spending, runaway inflation, a lack of property rights—contribute to substantially more volatile and pronounced market cycles. In the "typical" Latin American recession within the period of 1970 to 1994, output fell by an average 8 percent. In the OECD countries—a group of 30 rich, developed markets—it fell by 2 percent.^[64] A similar trend appears in the stock market. Based on annual returns since 1988, Latin America is 30 percent more volatile than emerging markets as a whole.^[65] Several of these episodes stand out, and the remainder of this chapter will be devoted to better understanding their significance.

In the aftermath of World War II, the US assumed a dominant role in reshaping the world order. The Marshall Plan sent hundreds of millions of dollars to Europe to rebuild after the devastation of war. Meanwhile, an age of consumerism took hold in the US, and Americans developed a thirst for imported goods from around the globe. As a result, US dollars in global circulation increased markedly. Foreign companies often kept this currency in the custody of their local bank, but other countries held the monies in US-domiciled financial institutions.

This was also the start of the Cold War, and the Soviet Union didn't trust US banks. It had good reason—during the war, the US government impounded Soviet dollar holdings. Yet Soviet officials didn't wish to surrender their dollar claims. Seeking alternatives, they found a British bank willing to offer US dollar deposits. This suited the Soviets. The bank was not domiciled in the US and thus not subject to its banking laws—the money was beyond the reach of US authorities. The arrangement was also agreeable to the British bank. It could take Russia's dollar deposits, turn around, and lend it somewhere else. Along with other minor precursors, this would soon put what was called the Eurodollar market on the map.

The Eurodollar market—comprised of a network of international banks—facilitates this very simple function: Providing access to US dollars outside of the US. Banks domiciled around the world can access short-term US dollar financing through the Eurodollar market. Today, it is one of the largest international capital markets.

What does the Eurodollar market's rise have to do with Latin America? Oil!

In 1973, the Organization of Petroleum Exporting Countries (OPEC) cut production and placed an embargo on its oil exports. The US and the Netherlands were targeted in particular (the Arab world was retaliating their decision to supply arms to Israel in the Yom Kippur War), but the entire world was dramatically impacted. At the time, OPEC provided just over 50 percent of the world's oil supply.^[68] Not surprisingly, oil prices shot through the roof from the dramatic reduction in supply—increasing 237 percent in January 1974 alone.^[69] Oil prices jumped again in 1979 when the Iranian Revolution shuttered Iranian oil exports and set off a global oil panic. That year, prices rose nearly 150 percent^[70] (see Figure 3.1).

Oil-exporting nations found themselves flush with cash as a result of the price increases. Between 1972 and 1974, OPEC's annual oil revenues jumped from $14 billion to nearly $70 billion. By 1977, they had nearly doubled again to $128 billion.^[71] This was more money than these nations could possibly consume, so their current account surpluses grew quite large. Where did this money end up? That's right, the Eurodollar market. By 1978, OPEC had approximately $84 billion in bank deposits, mostly in the Eurodollar market.

Figure 3.1. Brent Crude Oil PricesSource: Global Financial Data.

If rising oil prices led to current account surpluses in oil-exporting nations, the opposite must also be true: Current account deficits exist in oil-importing nations. High oil prices were a boon to those countries fortunate enough to have an abundant source of "black gold," but the rising cost of oil imports meant countries on the other side of the fence were correspondingly worse off. Many Latin American countries fit this bill. Combined with the social welfare spending associated with populist governments, the region saw its deficits grow, leaving it in need of funds.

Up to this point, emerging market nations had largely relied on other governments or international organizations for funds. But developed country governments were hesitant to lend at the time—they had their own problems.^[73] Borrowing from oil-rich countries was also not politically viable—these countries profited for the same reason Latin America suffered.

Figure 3.2. Total Latin America External DebtSource: The World Bank Group. Data are based on the Latin America & Caribbean group as defined by the World Bank.

Latin America tapped into another source—the Eurodollar market. Commercial banks across the globe were happy to provide funds to Latin American governments. Banks saw little risk in passing on credit to these countries. The common parlance at the time was "governments don't go bankrupt." The growth in lending over the next decade was staggering: Major international banks increased their loans to Latin America at an average rate of 30 percent a year for 10 years.^[74]

Throughout the 1970s, the region devoured this recycled oil money. Figure 3.2 illustrates the magnitude. The rate and scale of Latin America's debt accumulation was unmatched—by the early 1980s, the debt burden had jumped well over $300 billion.

Given the sheer size of the debt accumulated, the ability to service it became a critical variable. By 1982, Latin America was paying nearly 50 percent of export earnings to service its debt, with some countries, like Brazil, forking over even more. Bankers generally considered 30 percent an acceptable level.^[75] Foreign capital inflows turned to mild outflows around this time, as investors worried debt levels had approached unsustainable levels.

Matters were complicated by an additional factor. Approximately two-thirds of the debt accumulated paid variable rates, meaning the interest rate reset periodically. In this case, the rate was tied to the London Interbank Offering Rate (LIBOR) and reset every six months or so.^[76] LIBOR is the rate quoted by European banks to borrow US dollars on the Eurodollar market (the cost to borrow dollars outside of the US). In a relatively benign interest rate environment this wasn't an issue. But it left Latin American countries subject to macroeconomic conditions outside their borders.

Those conditions worsened materially toward the end of the 1970s. The decade's second oil shock sent US inflation soaring—prices rose by 13 percent in 1979, a very high rate for a developed country.^[77] In August 1979, President Jimmy Carter appointed Paul Volcker head of the Federal Reserve. Intent on crushing inflation, Volcker raised interest rates higher than any other time in modern US history. Rates on three-month Treasury bills soared above 17 percent in 1980 (see Figure 3.3).^[78]

Figure 3.3. US 90-Day Treasury Bill YieldsSource: Global Financial Data.

Volcker successfully tamed inflation—prices rose only 4 percent in 1982—but his actions were not without consequences. His aggressive monetary policy helped push the US into a deep recession, which soon reverberated throughout the globe.

Higher interest rates and slow growth were a double whammy to Latin America. Since their LIBOR debt was tied to US interest rates, servicing costs immediately spiked. At the same time, slower growth left governments with less revenue to meet the expanding payments. The situation worsened quickly—countries took on additional debt solely to make interest rate payments on existing debt, a veritable Ponzi scheme. Such a situation was untenable and destined to collapse.

And collapse it did in August 1982, with Mexico's announcement it couldn't meet its scheduled interest rate payment. Mexico was in a precarious situation. Not only was the government smarting from higher interest rates, but revenues from oil, a major export, also fell with the global recession and sharp decline in oil prices that year. Mexico's default quickly rippled through to other debt-laden developing countries. By year end, nearly 40 nations were in arrears on their debt.^[79]

These bad loans had infected the entire global banking sector. At the end of 1985, global commercial banks had lent $217 billion, with US banks holding 42 percent of the loans; European banks, 37 percent; and Canadian banks, 8 percent. In the US alone, the nine largest banks made loans to these countries equal to 233 percent of their primary capital.^[80] Latin America's default had the potential to bring the world's financial system to its knees.

The scale and interconnectedness of the crisis snapped the developed world to attention. Governments and international organizations used every resource available—from swap lines to the Bank of International Settlements loans (the central bank of central banks)—to prevent a global financial collapse. By the end of 1982, the situation had cooled—the world wasn't coming to an end. The US economy began to show signs of recovery, and officials breathed a little easier. But while the initial response was coordinated and quick, policy responses in the next several years were too timid and failed to spur the necessary reforms for complete recovery.

Policymakers initially viewed the crisis as one of liquidity, not solvency. Officials believed the fundamental health of the troubled countries was largely sound, but that they were shut out of international capital markets. That is, Latin American governments couldn't pay their debt because investors were too scared to give them money. Developed market nations, especially the US, were therefore against forgiving any part of the debt and pushed for postponement instead. The initial policy response gave Latin American governments enough loans to service their debt, requiring IMF-like austerity measures to resuscitate economic growth. These measures included tax and tariff increases and a prescription to reduce spending. If growth successfully returned, so too would investors and the necessary liquidity—or so the theory went.

Unfortunately, this was equivalent to using painkillers to treat an infection. It masked the pain but did little to cure the underlying problem. Troubled governments were largely able to meet payments with the additional loans, but austerity measures did little to invigorate growth, let alone attract foreign investors.

It was clear after a few years this solution was ineffective. The prospects of a return by investors seemed dim, and debt levels continued to rise (see Figure 3.2). In 1985, US Treasury Secretary James A. Baker introduced a new plan offering $9 billion from multilateral agencies and $20 billion from commercial banks in exchange for market- based reforms. Many of these reforms were different from those first proposed: tax cuts, a reduction of trade barriers, and the privatization of state companies. But the plan still included no forgiveness—policymakers remained staunchly in favor of postponing the debt. The Baker Plan was thus of a similar vein as the previous efforts.

By the end of the decade, it became clear the Baker Plan was also a failure. Developed nations realized these troubled countries couldn't service their debt and grow at the same time. The US government finally relented and agreed debt relief was a necessary condition for the region's recovery.

In 1989, the new US Treasury secretary, Nicholas Brady, announced the Brady Plan. It was a "voluntary" program that included various options for debt relief and restructuring, depending on the needs of a particular country, including swaps, debt exchanges, debt buybacks, and, most importantly, debt forgiveness.

Each country followed a slightly different path, but Mexico provided the model. Representatives of more than 500 global banks and members of Mexico's government met to negotiate a set of options banks could use to change their exposure to Mexican debt. Three options remained on the table by the end, which became generally known as "Brady Bonds":

Nearly half the banks agreed to swap their loans for the discount bonds, while 41 percent chose par bonds and 10 percent gave new money. For forgiving part of Mexico's debt, the banks were given something in return—the backing of the US government.^[81] The principal and interest of each bond were securitized by US Treasury bonds, meaning they would receive the full value of their investment in the chance the developing nation defaulted again before the debt term ended (this of course assumed the US would stay solvent, a very likely scenario).

By 1994, 18 countries saw $60 billion of debt forgiven under the Brady Plan, representing nearly $200 billion in bank claims. Most deals forgave about 30 to 35 percent of a country's debt.^[82] This debt forgiveness, along with the implicit default protection by the US government, proved largely successful in the ensuing years. With the debt burden reduced, more money flowed through the Latin American economy, stimulating consumption and investment.

Figure 3.4. Latin America Economic GrowthSource: The World Bank Group; based on the Latin America & Caribbean group as designated by the World Bank.

Not surprisingly, the 1982 debt crisis had dire economic consequences for Latin America. As a whole, the region fell into recession, as illustrated by Figure 3.4. Individual countries were hit harder still—Peru's economy contracted by a whopping 9 percent in 1983.^[83]

Latin America rebounded shortly thereafter, but it was a dead cat bounce. Massive debt levels remained, and the economy soon turned downward again. Populist-oriented governments found the prescribed therapy difficult—spending cuts were just too bitter a pill to swallow. Argentina, for example, saw its deficit swell from an already large 15 percent of gross domestic product in 1980 to 1984 to 24 percent in 1985. While the extra government spending provided a boost in the short term, it crowded out vital private investment. Argentina's investment plummeted from an average 22 percent of GDP in the 1970s to 13 percent during the crisis.^[84]

Contrast Latin America's recovery to Asia's following its financial crisis discussed in Chapter 2. While Latin America toiled in the economic mud for nearly a decade, Asian economies were quick to rebound—East Asia grew 6 percent in 1999, two years after its crisis, and averaged nearly 9 percent growth in the eight years through 2007.^[85] Why were the recoveries so different? The key distinction is political. Asian policymakers quickly swallowed the necessary medicine. But populism left Latin American governments unable to resist the demands of highly mobilized social interests. Latin America's long history of boom-and-bust cycles can be partly attributed to its choice in political models.

When the misery of 1982 arrived, Brazil's military government understood the need for a new government built on widespread consensus. The country's industrial-led economic growth "miracle"—from 1968 to 1974 the economy grew at an average yearly rate between 10 and 11 percent—had given way to hyperinflation and labor unrest.^[86] And the debt crisis brought the country perilously close to insolvency. Free elections were held at the municipal, state, and federal levels, and the government-approved party won a majority in the electoral college, which was due to vote for a new president in 1985. But the government-approved party was unable to build a consensus, and the opposition party, led by Tancredo Neves, unexpectedly won the presidency.

The masses rejoiced. Neves was a popular figure because he symbolized an end to military rule. From Sao Paulo to Rio de Janeiro, overjoyed citizens showered paper from office windows, blared their car horns, and set off firecrackers. In towns and villages across the country, Brazilians celebrated, literally dancing in the streets.^[87] Sadly, Neves was unable to consummate his victory. He passed away before inauguration, leaving the mantle to his vice president, José Sarney.

Sensitive to Neves's popular support and the transitional symbolism behind his rise to power, Sarney began his administration with a keen eye toward appeasing the masses. Not surprisingly, the economy was the biggest concern at the time. Inflation remained stubbornly high from the previous period of industrialization, and the debt crisis had left people agitated about the future. Sarney refused support from the IMF—a popular decision given prevailing nationalist sentiment. He instead announced his own proposal for economic resuscitation, the Cruzado Plan, in 1986. The plan was wide in scope and included price freezes and wage increases between 15 and 34 percent. These policies were very popular—who wouldn't like more money to spend on cheaper goods? A massive consumer boom ensued, and Sarney's popularity surged along with it—opinion polls put his approval rating around 80 percent.^[88]

But like virtually every populist government before him, Sarney had difficulty reconciling his social welfare promises with the need for capital. The Brazilian economy was brittle, still struggling under a huge debt burden. Despite a recovery in exports, debt repayments still consumed about a quarter of export earnings.^[89] Sarney couldn't acquire more debt under such circumstances. Slashing spending, however, meant cutting the social programs underpinning his popularity—anathema to a populist. Sarney thus chose the only recourse politically available to him: monetary expansion and additional deficit spending.

The Cruzado Plan achieved its political objective. In November 1986, Sarney's party won landslide victories at federal and state elections. However, the deficit financing underpinning the plan sent inflation even higher. Brazil has a long history of high inflation, but Sarney's monetary expansion propelled it to unimaginable heights. Inflation leapt to 629 percent in 1988 and to a remarkable 2,948 percent in 1990 (see Figure 3.5). This meant prices doubled roughly every month!

Sarney tried in vain to enforce wage and price freezes to stop inflation's rampant rise. But the powerful trade unions and industrialists would have nothing of the sort—Sarney had conceded too much to win their support. In a last-ditch effort to cater to the masses, Sarney attempted to redistribute land to help the 10 million landless peasants.^[90] Such action met with violent backlash by the large landowners and forced the government to retreat.

Toward the end of the 1980s, the masses began revolting. Riots over escalating food prices and widespread strikes were common. Sarney's political capital all but evaporated, and his party lost crucial positions at municipal elections in 1988. In 1989, he lost his hold on the presidency. The economy plummeted into recession, contracting 4 percent in 1990.^[91]

Figure 3.5. Brazil InflationSource: International Monetary Fund.

It's probably not too shocking that Brazil's stock market performance over this time was similarly turbulent. To manage hyperinflation, the Brazilian government repeatedly devalued its currency. On February 28, 1986, the Brazilian cruzado replaced the cruzeiro at a rate of 1,000 to 1; on January 15, 1989, the new cruzado replaced the original at the rate of 1,000 to 1. Several other devaluations occurred in the ensuing years and each effectively wiped out the value of the stock market, which fell by 99.99 percent in 1986 and 72 percent in 1990.^[92]

Brazil's newly elected president, Fernando Collor de Mello, helped ease inflation by doing the politically unpopular: He cut spending, privatized state companies, and dramatically cut public employment. This was the necessary medicine Sarney's populist administration was politically unwilling to provide. But it was only temporary. Collor de Mello resigned in 1992 due to allegations of corruption, and hyperinflation returned. Ironically, it seemed Brazil's economic progress was at odds with social order.

In retrospect, Sarney's administration followed a fairly predictable pattern common in populist regimes. A charismatic politician wins the favor of the people with promises of economic betterment and wealth redistribution. His popularity soars as his deficit spending-fueled policies spur a brief period of expansion. Soon, rising deficits and inflation get out of hand, erasing gains for the poor. The administration tries a few last-ditch efforts at austerity, but its days are largely numbered. This cycle is repeated ad nauseam through Latin America's history, to negative effect.

In the years following the 1982 debt crisis, a new political class achieved an increasingly influential voice in Mexico. Politics had long been dominated by the "old guard" within one party—the Partido Revolucionario Institucional (PRI)—and a patronage system that stifled anything but the status quo. This new class challenged that existing order. They were educated at top US universities, spoke fluent English, and firmly believed stability came from liberal economics and its tenets: low inflation, stable budgets, deregulated markets, and free trade.^[93] In 1985, President Miguel de la Madrid used these principles to lay the seeds of recovery, and his successor, Carlos Salinas, germinated them.

De la Madrid correctly saw the vicious cycle of hyperinflation as his administration's most pressing problem. Inflation had taken on a life of its own. Price increases in goods quickly translated to higher wage demands by workers, which in turn led to even higher prices for goods. Inflation averaged nearly 90 percent a year through the debt crisis, hitting a high of 132 percent in 1987. De la Madrid recognized this negative feedback loop needed a new remedy. His program for economic renewal stressed cooperation and coordination in wage and price setting. And it worked—inflation fell to 20 percent by 1990.^[94]

Addressing the broader economy, de la Madrid believed in tearing down trade barriers and opening Mexico to the rest of the world. In 1986, he brought Mexico into the General Agreement on Tariffs and Trade (GATT), the predecessor to the World Trade Organization (WTO). Salinas continued the trend, slashing tariffs and signing free trade agreements with many of its Latin American neighbors. Salinas also began negotiations that would lead to NAFTA in 1994.

De la Madrid and Salinas also embarked on the largest deregulation and privatization in Mexican history. More than 3,000 sectors were deregulated, including foreign investment, trucking and bus transportation, and, most importantly, the financial system (which was nationalized in 1982 in a last-ditch attempt to shore up support following default).^[95] The scale of change in the mid- to late 1980s was remarkable: Interest rate controls were eliminated, restrictions on the convertibility of the peso removed, and requirements mandating lending to favored sectors abolished. The amount a bank must set aside as collateral with the central bank for a given level of deposits—the reserve requirement ratio—was also drastically cut, freeing funds to find more productive hands.

Still, it wasn't until the Brady Plan removed the last major impediment to recovery in 1989—Mexico's large debt burden—that the previous year's reforms gained traction. The plan's success opened up the floodgates of economic liberalization.

The overall debt relief from the Brady Plan was relatively modest, but it marked a psychological turning point for Mexico. The debt problem receded from domestic political debate, and the plan imbued new confidence, leading to substantially lower interest rates. Within a year, the private sector again sprung to life. It devoured the foreign goods that came with trade liberalization, and banks capitalized on deregulation to expand lending, fueling further consumption and investment. Mexico's current account, which moved to surplus following its default, quickly swung back to deficit. As discussed in Chapter 2, a current account deficit must be matched by a corresponding capital account surplus, meaning Mexico needed additional funds to maintain the increased consumption. Fortunately, Mexico's reforms were not unnoticed by foreign investors.

Around this time, the structure of global capital markets began to change. The days when foreign bank loans dominated financing for emerging markets were passing, as portfolio flows played an increasingly important role—investment managers across the world were discovering exciting new opportunities in emerging markets. In Mexico's case, another key event spurred interest in its markets: US interest rates declined at the beginning of the 1990s as the Federal Reserve fought off recession. With confidence in Mexico already rising, it offered an easy alternative to its yield-deprived neighbors to the North.

Money flowed in, creating a virtuous cycle: Capital inflows led to further increases in bank lending, which further stimulated investment and consumption. In 1993 alone, over $30 billion in foreign capital was invested.^[96] Fattened by the inflows, Mexico's banks became international leaders. In 1992, three of the 25 most profitable banks in the world were domiciled in Mexico. By 1993, that number was seven.^[97] Equity markets were also red-hot. In the six years ending in 1993, the stock market rose 61 percent on average each year. In 1991 alone, the Mexican market leapt 121 percent!^[98] The media began talking of a "new" Latin America and the "Mexican miracle."^[99]

But warning signs were brewing on the horizon. Mexico's currency, the peso, was restricted to a band against the US dollar in 1991, with the lower end of the band set to decline by a small amount each day to allow for gradual depreciation. Yet the scale of inflows meant the actual rate continuously hit the high end. In time, many observers began loudly worrying the peso was overvalued.

There were also signs banks were becoming lax in their lending. Despite all the reform, structural inefficiencies remained in the banking system. For example, there was no central credit bureau to help lenders evaluate a borrower's creditworthiness. Regulatory oversight was minimal. By the end of 1993, however, such concerns were of no consequence to Mexican authorities, as they continued to encourage bank lending and consumption.

Meanwhile, two key events seemed to cement Mexico's ascension to the world stage. On New Year's Day 1994, the North American Free Trade Agreement (NAFTA) took effect. Mexico's growing industry now had unencumbered access to the world's biggest market—the US. In March of the same year, it entered the Organisation for Economic Cooperation and Development (OECD), the world's preeminent club of rich countries.

But militants in Mexico's Chiapas region had different ideas. The reform years left the country's poor agrarian workers struggling beneath the veneer of economic revival. Mexico's technocrats and elites benefited from the newfound interconnectedness to the global economy, but rural residents remained destitute and increasingly disenfranchised. Chiapas was one of Mexico's poorest rural regions, and its residents reacted violently to the signing of the agreement. The outbreak was quickly quelled by the government but served as a brutal reminder of Mexico's problems.

A few months later, Luis Colosio, Carlos Salinas' hand-picked successor, was assassinated on the campaign trail. With the Chiapas uprising still fresh in investors' minds, additional political turmoil was too frightening a prospect. Foreign capital inflows quickly dried up and began to reverse. Mexico's rise was quickly jeopardized by two unexpected exogenous shocks.

Faced with a massive exodus of capital, Mexican authorities needed to react quickly. Officials could raise short-term interest rates to entice investors to keep their cash in pesos. But this rise in interest rates would hurt consumers and businesses, not to mention exacerbate the non-performing loans accumulated on bank balance sheets. They could reintroduce restrictions on the convertibility of the peso, essentially prohibiting foreign investors from exchanging the currency. But that would call into question the country's adherence to economic liberalism, a key driver behind the recent boom. Or they could devalue the peso, which was fixed to a band since 1991.

Authorities chose the latter, but it took time before they completely acquiesced. In the months following Colosio's assassination, the government used foreign exchange reserves built up during the years of inflows to offset outflows. But these reserves were not large enough to avert crisis for long. Rather than admit defeat and devalue, the government began issuing tesobonos—short-term government bonds indexed to US dollars—to supplement reserves. Officials used these borrowed funds as part of its peso defense. This strategy left Mexico increasingly vulnerable to a liquidity crisis; the government needed to roll over this short-term debt every few months in addition to satisfying its other foreign creditors.^[100]

The confidence inspired by the Brady Plan was evaporating, and interest rates on one-month Treasury bills more than doubled in December 1994 to 31 percent.^[101] The pressure was soon too much. Mexico finally caved on December 20 and devalued the peso by widening its trading band by approximately 15 percent (see Figure 3.6). But the devaluation wasn't large enough to appease speculators. The market immediately began pricing in a second round. Just two days later, authorities were forced to freely float the peso.^[102] It immediately sunk like a stone.

The most immediate problem was the deterioration of Mexico's fiscal position. Mexico issued billions of tesobonos during its currency defense, leaving it acutely exposed to moves in the peso/US dollar exchange rate. With the peso plummeting, the value of this debt soared. To make matters worse, as the news of the tesobono problem spread, panic set in, and investors rushed to sell their bonds—yet another vicious cycle.

Figure 3.6. Mexican Peso vs. US DollarSource: Thomson Datastream.

By now, you should know what's coming next: Mexico's economy collapsed, and the "Tequila Crisis" was born. Economic growth contracted by 6 percent in 1995—nearly double the fall following the 1982 debt crisis. The local stock exchange, the Bolsa Mexicana de Valores (BMV), also crashed, falling 44 percent in 1994 and 23 percent in 1995. It would be nearly 10 years before the BMV returned to the same level. As in previous crises, Mexico's implosion soon infected other Latin American countries, despite no fundamental connections. Argentina was particularly hard hit. Speculators attacked its currency, and its financial system nearly collapsed.

With few financial resources of its own, Latin America turned to the outside world for help. And again the Western world obliged; the US Treasury extended a $50 billion line of credit to Mexico, and Argentina received $12 billion from the World Bank. But unlike the several years of slow healing following the 1980s debt fiasco, Mexico made a remarkably swift recovery. In a few years time, the next boom had begun.

The Tequila Crisis is yet another reminder to investors that economic success and media admiration don't make a country immune to crisis. While the Mexican government made clear policy errors, including ignoring an overvalued exchange rate and letting credit spiral, there are several broader implications important to investors.

The Importance of Politics in Emerging Markets

Last, Mexico's experience with the Tequila Crisis reveals how quickly the political environment can impact markets, particularly in volatile emerging markets. Investors were wildly optimistic about Mexico's liberal market reforms and economic prospects. But it is the unexpected that moves markets. The revolt in Chiapas and assassination of Luis Colosio quickly overwhelmed any prior positive developments, sending markets into a tailspin. While it's difficult to predict these types of events, investors should always include an analysis of the political environment in any investment decision (more on this in Chapter 6).

Chapter Recap

• Its flirtation with populism encouraged reckless fiscal and monetary policy as governments struggled to reconcile social welfare promises with the need for capital, often to devastating effect.

  • Populist policies exacerbated the volatility of Latin American capital markets, promoting hyperinflation, excess debt levels, and wealth redistribution. The events surrounding the 1982 debt crisis illustrate these struggles.

• Mexico in the 1990s reminded investors of the four most dangerous words: "It's different this time."

  • Media adoration and positive reforms masked the country's over-reliance on foreign debt—a common theme throughout Latin America's history.

• With nearly continuous cycles of boom and bust, it's easy for investors to casually dismiss the region and eschew the volatility.

• But the region's vast resources and economic potential warrant consideration. To successfully invest in Latin America, however, investors must remain cognizant of its cyclical past.