1990s, many pointed to Mexico as a splendid example of successful economic policy reform.Mexico had even negotiated the North American Free Trade Agreement with Canada and the United States, thus contemplating a highly open economy in future years.In December 1994, however, a new Government came to power.Recognizing that the exchange rate was somewhat unrealistic, it attempted a 15 percent devaluation.Instead of improving the situation, however, that devaluation triggered a major foreign exchange crisis, as Mexican citizens and foreigners alike attempted to get out of pesos and peso-denominated assets and into dollars.With foreign support and further policy measures, the markets ceased to panic and the virtual free-fall in the exchange rate and government debt stopped.To help reduce nonperforming loans in the banks' balance sheets, the government provided for the banks to transfer part of their loan portfolio to the government, and gave the banks nontransferable ten-year government bonds in exchange.While Mexican real GDP fell at rates of 9.2, 8.0 and 7.0 percent in the last three quarters of 1995, real GDP then began increasing in the second quarter of 1996, and grew at average annual rates above 5 percent through the first quarter of 1998. 1 This remarkably quick recovery in aggregate activity has not been uniform across the economy.The tradable sector has grown strongly, while after a steep fall in 1995 the non-tradable sector has subsequently recuperated only sluggishly.Mexican exports, which had grown at an average annual rate of 5 percent from 1 The only exception was the first quarter of 1997 when the growth rate was "only" 4.9 percent.But that was followed by expansion of 8.6 percent in the second quarter of 1997.1985 to 1994 and were U.S. $74 billion in 1994, grew at an average rate of 21 percent from 1994 to 1997, and stood at $126 billion in 1997. 2 The asymmetric response of the tradable and non-tradable sectors is intimately linked with the severe credit crunch that Mexico has experienced since 1995.Although fresh domestic bank lending dried up in Mexico, it was still possible for export firms to obtain financing in the international capital market, or to receive credit from upstream firms.Hence, the credit crunch did not deter the tradable sector from growing at spectacular rates.On the other hand, firms in the non-tradable sector were adversely affected by the lack of credit, as these firms had no access to international financial markets.Instead, such firms have had to finance themselves with their own resources.A phenomenon that has gone hand in hand with the credit crunch is the steady increase in the share of non-performing loans.Even after deducting the bad loans transferred to Fobaproa, the ratio of nonperforming to total loans in the balance sheet of commercial banks increased from around 10% at the end of 1994 to 16% in 1995 and subsequently to 21% in 1996.In 1997, this ratio rose to 30%, a sizable increase, indicative of a change in banking regulation that directed banks to classify the principal in addition to the unpaid interest as non-performing.From an ex-ante perspective the partial bailout policy pursued by Mexico seemed appropriate.In principle one would expect that high GDP growth would increase firms' profits and households incomes.As a result debtors would be able to service their debts, and banks would be able to expand credit.However, with hindsight we can see why this policy stance did not solve the banking problem.First, export firms financed themselves in international capital
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