MEXICO'S FISCAL PROBLEMS IN THE NINETEENTH CENTURY

Mexico's debt problems started at independence in 1821, when the Mexican Empire recognized 30 million dollars worth of colonial debts owed to domestic merchants. The debts were never repaid.⁸

The first Empire collapsed in 1823. In the following two years, the Republic contracted 32 million dollars of debt in London. By 1827, it had suspended payments. Debts contracted in the 1830s and 1840s also went into default. In 1851 the government refinanced the suspended loans of 1824/25. In 1857, however, Mexico defaulted yet again.

The French government used Mexico's debt arrears as a pretext to invade in 1862 and install Archduke Maximilian in Mexico City. Facing opposition from Benito Juárez's U.S.-backed guerrilla forces, the French pulled out in 1866, and Maximilian fell within a year. Unsurprisingly, the Restored Republic under Benito Juárez refused to recognize the debts contracted under Maximilian. In addition, because the British government had supported Maximilian, the Restored Republic suspended payments on all existing British debts. By the 1870s, unpaid interest on the British debt alone had ballooned to US$120 million.⁹

Mexico's debt during this period can be seen in Table 1.

Sebastián Lerdo de Tejada succeeded Benito Juárez upon Juárez's death in 1872. Porfirio Díaz overthrew Lerdo in 1876. Díaz ceded the Presidential sash to Manuel González in 1880. (He would take it back in 1884.) Although all three governments neglected the foreign debt, they all tried to amortize some of the domestic debt. Juárez bought back a small amount of debt in 1868, for 31 percent of its face value. An 1870 report to Congress indicated that the 1850 convention bonds traded at 8 to 9 percent of their face value, whereas more recent debts could be purchased for 15 percent.¹⁰

In 1876 Porfirio Díaz's new government purchased debt with a face value of Mx$2.1 million at 25 percent of par. In 1876, financiers held debt with a face value of 45 million pesos: the market value of this debt was closer to 11 million pesos.¹¹

Unfortunately, the government's need for credit had grown. Díaz needed to equip an army capable of facing down threats from regional challengers. He also needed to pay the army enough to keep its loyalty. His government, however, lacked the resources to effectively tax Mexico's impoverished economy. In 1877 Mexico's per capita GNP (in 2003 dollars) was only $473.¹²

Foreign trade was a potential source of revenue, but the country's small economy generated little foreign trade.

Mexico's leaders believed that railroads would open Mexico's economy to foreign investment, increase trade and tariff revenues, and allow Mexico to repay its obligations. Mexico had no decent navigable waterways, and half of all roads were unsuitable even for beasts of burden. Mexico's first railroad did not open until 1873, and by 1877 the country enjoyed only 400 miles of track.¹³

Constructing railroads, however, required federal subsidies. Railroads were capital intensive, required long time-horizons, and demanded detailed knowledge of the terrain, economic conditions, and prospects for future growth. They also required specialized engineering and management skills. In an unstable polity, few private investors were prepared to risk substantial amounts without federal subsidies.¹⁴ The federal government, therefore, found itself trapped in a fiscal Catch-22. Without railroads, there was little economic activity to tax; without subsidies, there were no railroads. This was recognized by Mexico's foreign creditors in 1878, when they agreed to link the renewal of debt service to future railroad growth. In the words of the Finance Secretary, Matías Romero:

Mexico's existing sources of credit were not sufficient. A money market of sorts existed in Mexico City. The federal government issued customs certificates that entitled the bearer to physically go to a specific customhouse and collect a stated amount, and a secondary market existed for them. Gross issues of customs certificates rose precipitously between 1876 and 1882. (See Table 2.) Most funds, however, were paid back in six months, and net long-term borrowing was zero. Increases in railroad subsidies came out of the military budget, a dangerous policy in a country prone to regional revolts and military coups. In short, if the government were to build railroads quickly, it needed to borrow more than this thin market could finance. (See Table 3.)

There is no evidence that the Mexican government considered printing money to cover its deficit. There is a reason for that: inflationary finance had not been particularly successful elsewhere in Latin America. Argentina provides an example. On multiple occasions, Argentine governments filled fiscal shortfalls by printing money. None of these episodes raised revenues for more than a few years, and all were followed by painful efforts to re-establish convertibility. The mechanism behind inflationary finance in Argentina was not the issuance of government fiat money. Argentine governments (like Mexican ones) lacked the credibility to force people to accept their notes. Rather, the mechanism was to establish private banks that would issue notes redeemable in gold, and then suspend the convertibility of those notes.¹⁶

It was, in short, not unlike issuing interest-free bonds with a promise to repay in the future. Even had the Mexican government wanted to follow the Argentine example, it could not have persuaded the public to accept its note issues because it had already defaulted on its debts and its bonds traded for as little as 8 centavos on the peso.

The government, therefore, decided to create a bank. Emilio Velasco, a lawyer from northern Mexico acting in the employ of the federal government, used his contacts with Gustavo G. Godowa, the Polish publisher of the Mexican publication Le Nouveau Monde, to open negotiations with the Banque Franco-Egyptienne over the establishment of a bank that would serve as the primary financial agent for the federal government.¹⁷

After a year, an agreement was signed on 11 August 1881, between Edouard Noetzlin, the Banque Franco-Egyptienne's representative, and the Finance Ministry. The agreement established the bank as the federal government's financial agent, and stipulated that its banknotes would be the only ones recognized for federal taxes.¹⁸ Most of the new bank's capital came from overseas.¹⁹ Credit from the Banco Nacional Mexicano allowed the government to run a small budget deficit in the 1881/82 fiscal year.

The Banco Nacional Mexicano was not the only bank in Mexico. Four other formal institutions existed in 1881. One was a small bank founded by Americans in the frontier state of Chihuahua. The second was the Banco de Londres, México, y Sud-América, a British bank that had operated in Mexico since 1864.²⁰

The third was the Nacional Monte de Piedad. The Monte de Piedad began operations during the colonial era, advancing small amounts against goods presented to it as guarantees.²¹ On 6 September 1879 Governor José Ceballos of the Distrito Federal proposed that the Montepío be permitted to discount commercial paper and issue “deposit certificates” that could be turned in for specie. President Díaz agreed, and the Monte de Piedad became a bank on 1 October 1879.²²

The fourth bank was founded as a response to the Banco Nacional Mexicano. A group of enterprising merchants decided to found their own bank, claiming that it was their “patriotic duty” to invest in a “free” bank in order to stop Mexican capital from leaving “to increase other nations' prosperity.”²³

Ironically, most of the merchants who subscribed to the Banco Mercantil's stock had been born in Spain.²⁴ The Banco Mercantil claimed that competition between different banks for federal business would benefit everybody.²⁵

THE COMMITMENT PROBLEM

Why would the simple act of chartering a bank aid the government in solving its credit problem? After all, the French and Mexican owners of the new bank faced the same uncertainty as other creditors. The government could as easily suspend payments on bank debt as on bond issues. Of course, foreign powers could use military force to collect their debts. In fact, President Benito Juárez's refusal to honor the debts of the previous Conservative government prompted the French invasion in 1862. That adventure, however, turned into a fiasco. By the 1880s the only power that might be capable of forcing Mexico to repay its debts was the United States, but there is no evidence that the American government had any interest in doing so.

The only recourse creditors had to induce repayment was the threat of denying future credit. Therefore, the largest penalty which they could impose upon the Mexican government was the present value of any future borrowing.²⁶

It is difficult, however, for multiple lenders to effectively enforce a credit boycott. Boycotts hurt lenders almost as much as they hurt borrowers. The government will be denied credit, but its creditors will be denied the opportunity to make profitable loans.²⁷ With a multiplicity of lenders, the government can default on some while continuing to borrow from others. In fact, the government has no incentive not to default on any single lender. After all, the marginal value of the last loan the government takes at the prevailing interest rate is presumably zero, and therefore so is the cost of default and alienating that particular creditor.²⁸

Of course, lenders are presumably alert to this sort of thing. Therefore, one would expect lenders to organize a boycott if the government began defaulting on any of its debts. Unfortunately, collective boycotts are not credible without an enforcement mechanism. This is because the government can offer extraordinarily good terms to violators. The more restrictive the boycott, the greater the government's need for credit, and the more the government can credibly offer to pay violators. The value of the punishment lenders can levy via a boycott on the government will be low, and so will be the government's credit limit.²⁹

Therefore, by concentrating its borrowing in a single institution, the government can raise the amount of pain caused by a default, because a single lender can credibly impose a credit boycott. The result, in theory, is an increase in the government's ability to borrow. The rub is that the government has no binding ex post reason to limit its borrowing. If the government's demand for credit increases, then it will happily pledge to give one creditor a monopoly over lending while surreptitiously seeking out additional creditors. That is precisely what happened after 1884.

MEXICAN DEFAULT IN THE 1880s

In 1883 and 1884 the Mexican government reneged on its agreement with the Banco Nacional Mexicano. In order to circumvent its 4 million peso debt ceiling with the bank, Manuel González's government surreptitiously borrowed from a widely dispersed group of creditors, ran up a huge debt, and finally suspended payments. This behavior should not be surprising. Many of the railroad trunk lines had been finished by 1884, and as the year drew on it became increasingly obvious that President González lacked the political support to keep himself in power. Why not borrow as much as you can, while you still can? What is surprising about this episode is not that the Mexican government defaulted, but that it managed to regain access to credit within two years. By 1888, in fact, the Banco Nacional's successor bank would underwrite Mexico's return to the international credit markets.

What prompted the default? In 1882/83, federal spending began to outpace revenues. (See Table 3.) The government began issuing customs certificates faster than it redeemed them. It also requested advances from Mexico's other banks, in contravention of its agreement with the Banco Nacional. Changes in tariff schedules kept the deficit from growing in 1883/84, but the respite was temporary. In May 1883 the Banco Nacional Mexicano lent the federal government 150,000 pesos, followed in November by an additional loan of Mx$700,000 in exchange for Mx$1,000,000 in customs certificates due six months later.³⁰

The effective annualized interest rate was 104 percent.³¹ By mid-1884 the government had mortgaged 60 percent of the port of Campeche's customs revenues, 84 percent of Veracruz's, and 90 percent of Matamoros's and Tampico's, yet the government continued to promise future railway subsidies.³² This hidden debt grew faster than open borrowing.³³

Federal deficits caused foreign railway investors to doubt that the government could cover its subsidy promises. Therefore, they ceased investing. Imports of manufactured iron and steel, used primarily in railroad building, provide a rough proxy for investment. After rising from US$1.3 million in 1880 to US$4.2m in 1882, they fell to US$3.8m in 1883, slid to US$2.4m in 1884, plunged to US$1.2m in 1885, and bottomed out at US$904,554 in 1886.³⁴

The fall in foreign investment occurred at a bad time, because Mexico suffered a crop failure in 1884. With the government gobbling up domestic credit, foreign capital drying up, and specie flowing out to pay for imports of basic foodstuffs, rural bankruptcies multiplied. This slowed business activity, which caused imports to drop, which lowered the government's tariff revenue. That, in turn, increased the fiscal deficit, thereby worsening the credit crunch and exacerbating the crisis. Banks ceased lending.³⁵

In fact, the crisis brought down one of Mexico's banks, the Nacional Monte de Piedad, but the entire banking system was affected.³⁶ In January 1884 the government requested five million pesos from the Banco Nacional Mexicano. The Banco Nacional Mexicano could not meet this demand.³⁷

The solution was to engineer the merger of the Banco Nacional and the Banco Mercantil into a new bank called the Banco Nacional de México (henceforth Banamex). Edouard Noetzlin, the chief representative of the bank's French owners, arrived in Mexico in February 1884 to begin negotiations over the merger. President González placed Porfirio Díaz in charge of the government's team.³⁸

The new bank, Banamex, was largely owned by Mexican residents.³⁹

The agreement with the government, known as the “Noetzlin Contract,” gave Banamex a monopoly over all lending to the federal government.⁴⁰ The bank was also exempted from federal taxes, except the stamp tax, while the government promised to subject the other banks to a 5 percent tax on banknote issues. Banamex received the right to issue banknotes up to three times the amount of its reserves, which could consist of federal bonds in addition to specie, whereas its competitors were limited to a ratio of two pesos in notes for every peso of vault specie.⁴¹ The government also agreed to turn over half of the revenue of the Progreso, San Blas, and Mazatlán customhouses directly to the bank.⁴² In return, Banamex opened a four million peso credit line to the government, and soon offered more. By the middle of 1884 the government owed the new bank Mx$5,686,559.⁴³ By September, the government's debt to Banamex had increased an additional two million pesos.⁴⁴ Banamex also agreed to underwrite a conversion of Mexico's outstanding debt into £6,000,000 of sterling-denominated bonds at lower interest rates.

Unfortunately, the Noetzlin Contract ignited a political firestorm back in Mexico City when it was presented to Congress in October 1884. Several congressional deputies bitterly opposed the contract, objecting against the £1.3 million—roughly 20 percent—commission charged by Banamex. As Carlos Marichal has pointed out, these commissions were probably intended to cover the government's outstanding seven million peso debt to the bank. Nevertheless, before a final vote could be taken, hundreds of students took to the streets chanting, “Die, Manuel González! Die, Noetzlin!” Two people were killed and hundreds injured in the resulting riot.⁴⁵

Neither González nor Noetzlin died, but the contract did. Mexico City was in the midst of bitter in-fighting over who should succeed Manuel González. Porfirio Díaz presumably had little incentive to help his protégé-cum-opponent resolve the country's credit problems. Díaz regained the presidency and informed Noetzlin that both the contract and commission were dead.⁴⁶

The failure of the Noetzlin contract failed to shrink the government's demand for credit. Banamex charged the government an effective interest rate of 39.4 percent on a 300,000 peso advance made to make loan payments due in New York in January 1885.⁴⁷

In March the government illegally borrowed Mx$1,094,201 from Banamex through the expedient of not paying money orders drawn on New York.⁴⁸ In April the bank's board approved a further 300,000 peso “emergency” loan to the government.⁴⁹

On 22 June 1885 Finance Secretary Manuel Dublán announced what the contemporary financial press called a “coup-d'état”: the suspension of all interest payments on short term debt.⁵⁰

Deprived of credit, the government was forced to halt all subsidy payments and slash the salaries of state employees 10 to 15 percent.⁵¹ Banamex was left high and dry, and faced a very serious bank run. (See Table 4.) Its directors “agreed” to give the government until June 1886 to resume payments. In point of fact, the bank had little choice.⁵²

Within a year, however, Banamex opened new credits to the federal government.⁵³

In 1888 the bank aided the government in converting its outstanding foreign and domestic debts into new bonds at a much lower interest rate. In 1893 it underwrote the government's first fresh borrowing on international capital markets in a half-century.

PROFITS

Why did the bank choose to aid the federal government? After all, Banamex had been seriously burned by the government's suspension of payments and the subsequent bank run. Why risk good money after bad?

Banamex had three reasons. First, Banamex was, in effect, empowered to collect taxes on the government's behalf. Banamex became the official financial agent of the federal government, which meant that all tax payments and disbursements passed through its hands. In addition, Banamex held all deposits made as guarantees of government contracts. The bank's directors collected a 3 percent commission on these funds.⁵⁴

In fact, Banamex was given the right to collect or administer some taxes directly. In 1885 the government mortgaged 10 percent of all customs revenue (staring on 1 July 1886) to the bank.⁵⁵ In 1888 the administration of (and revenues from) the Veracruz customhouse and national lottery were given to Banamex.⁵⁶ In 1893 it was granted the right to the revenues from all federal excise taxes on alcohol in return for a loan of £267,500 to pay for railroad subsidies.⁵⁷ In 1893 in return for a loan of 2.5 million pesos, Banamex was granted administrative control over the federal mints. Banamex promised to continue kicking back to the government what it had previously earned from the mints (4.41percent for silver pesos and 4.618 percent for gold), but believed it could run the operation much more efficiently.⁵⁸ In other words, the government's chief creditor became, in effect, a tax farmer.

These arrangements benefited the government as well as the bank. The share of alcohol taxes in all internal taxes doubled the year Banamex took over their collection.⁵⁹

Federal revenues from coinage increased more than sevenfold in the years following Banamex's takeover (see Table 5). In short, not only did the government gain from these arrangements by gaining access to credit; it also improved its fiscal position directly.⁶⁰

Second, the government enabled Banamex to extract rents indirectly from the rest of the Mexican economy. The Banco de Londres y México was the only bank besides Banamex permitted to branch across state lines. Banamex could enjoy economies of scale and diversify its risks in a way that the smaller banks could not. The federal government protected Banamex from new startups, authorized by state governments, by federalizing all bank chartering in 1884.⁶¹

Banamex's role as the government's financial agent gave it a secure source of liquidity (and 3 percent commissions) not enjoyed by its competitors. In addition, the government promised Banamex a monopoly over issuing banknotes.⁶² The Banco de Londres y México used its political influence to prevent Banamex from fully exercising its banknote monopoly, but Banamex still enjoyed a great deal of protection from competition, because only its notes were acceptable for federal tax payments. The government lacked the capacity to extract these rents—a monopolistic position in the capital market only generates profits if you have capital to invest—but it could enable Banamex's owners to do so.

In 1888, under pressure from the state governors, the federal government granted concessions for 14 new banks. These concessions worried Banamex, although only half of the new concessions allowed their holders to issue banknotes.⁶³

The financial press, however, was more sanguine. When the Banco de Sonora opened its doors in 1889, the Economista Mexicano observed that “the Banco de Sonora has not been conceded the innumerable franchises and exemptions that the privileged Banco Nacional de México enjoys.”⁶⁴ The press turned out to be correct. None of the concessions that lacked the right to issue banknotes ever opened their doors.⁶⁵ Of the seven concessions that resulted in bank openings, three failed and none of the others were allowed to branch outside their home state. Nor were they allowed to issue more capital without the explicit permission of the Finance Secretary (who always said no) and their note issues were very carefully monitored. As a practical matter their banknotes failed to circulate outside their home state.⁶⁶

Third, Banamex was able to use its position as the government's official financial agent to reap enormous profits from underwriting the government's debt conversions. In other words, Banamex was able to extract rents from the government's former creditors, in return for the hope (which turned out to be well founded) that the written-down debts would be repaid.

The government used Banamex as an intermediary to negotiate the conversion of its outstanding debts. In 1886, the government persuaded its British creditors to write off its outstanding interest arrears. That same year, domestic claims with a face value of 57 million pesos were converted to 3-percent bonds worth approximately 25 million pesos. In 1888 Banamex arranged a European conversion loan. The proceeds from the new loan were used to pay off the government's existing debt to Banamex and buy up Mexico's outstanding foreign obligations at 40 percent of their face value. The country's creditors wrote off 37 percent of Mexico's foreign debts, for a net saving of £8.7 million.⁶⁷

Banamex received a commission worth 0.5 percent on the entire value of the operation.⁶⁸ In addition, it received 18 percent of the profits from underwriting the sales of the new bonds in Europe. This amounted to 29 percent of Banamex's total profits for 1888.⁶⁹ Noetzlin took an additional private commission worth one million pesos. In fact, the underwriters' profits were so high that the London Times criticized the transaction. “The only explanation,” they wrote, “is that the Mexican government are greatly harassed by the persistent demands of the National Bank of Mexico to repay loans which are of long standing.”⁷⁰

What the Times did not understand was that the transaction was good for all the parties involved. The government reduced its outstanding debt and began rebuilding its international reputation. Banamex divested itself of the government's outstanding debt and earned high profits. Mexico's foreign creditors got to exchange moribund debts for lower debts that might be—and, ex post, were—repaid. Later conversions in 1889 and 1890, and new debt issues in 1892 and 1893, followed the same pattern. In 1892 and 1893, for example, the government found it difficult to place its bonds in Europe. Banamex underwrote the loans, buying the entire bond issue from the government, and waited a year to re-sell them on the European market.⁷¹

How high were Banamex's profits? The answer is: extremely high. (See Table 6 and Table 7.) The bank earned an average return on equity of 24 percent. By 1888 the bank's owners had earned back their entire eight-million peso investment. As might be expected, the bank paid out the majority of its profits in dividends, and reinvested very little.

During the 1880s Mexico was an inflationary economy as the silver peso depreciated against gold. The figures in Table 7 have therefore been adjusted by the Gómez-Musacchio price index (which begins in 1886) in order to adjust for changes in the price level. Despite inflation, profits were still very high. Real returns averaged 23 percent in 1886–1898.