Peso Plunges as Mexico Lets the Currency Float : Economics: U.S. activates a $6-billion line of credit. News is bad for Mexicans facing loss of buying power.

MEXICO CITY —  The Mexican currency plummeted Thursday--losing a fifth of its value--and the Mexican stock market fluctuated wildly in frantic trading after President Ernesto Zedillo’s government stunned international financial markets and this nation by permitting the peso to float freely against the U.S. dollar.

The United States and Canada, its partners in the North America Free Trade Agreement, immediately rushed to aid Mexico, which suddenly has been enmeshed in political and economic turmoil.

U.S. Treasury Department officials confirmed Thursday that they are activating a $6-billion line of credit for the Mexican Central Bank, which can also call upon $1 billion in Canadian loan credits to shore up this nation’s economy.

While diplomats and financiers in New York, Washington and Mexico City scrambled to limit the damage, U.S. shoppers poured into Tijuana in a light rain. Among them was Tim Mulholland of Reseda, who paid $50 for a pair of boots that he expected to cost $90--the good news about a fiscal crisis that has enhanced the buying power of the dollar in Mexico by about one-third in just three days.

“I came down for some Christmas shopping, and I was pleased. People were real nice,” Mulholland said.

But the news is not so good for Mexican citizens, who suddenly face a shrunken peso and rising interest rates, all in the name of slashing their country’s unmanageable trade deficit and strengthening the economy in the longer term. A 60-day wage and price freeze was also imposed to contain the damage.

Mexico requested the emergency credit line, part of the NAFTA agreement that took effect Jan. 1, after Treasury Secretary Jaime Serra Puche announced the floating of the peso. The funds will help bolster Mexico’s foreign exchange reserves, which Serra disclosed had plummeted to $6.5 billion--the result of months of government buying to defend the peso at overvalued levels. The reserves stood at $17 billion as recently as Nov. 1.

Within hours of announcing what the government called an extreme measure to stabilize the peso at rational levels and blunt the impact of political instability in the embattled southern state of Chiapas, thousands of Mexicans lined up at exchange houses to sell off the Mexican currency. Mexican stocks traded in New York fell sharply.

Most Mexican economists said the government move spread anger, resentment and a crisis of confidence in Zedillo’s government just three weeks into his term--and three days before Christmas.

In a speech to Mexican economists late Wednesday, Zedillo had stressed that he believed radical measures were necessary to deal with the uncertainty resulting from an Indian-led uprising in Mexico’s southernmost state. He insisted that the actions ultimately would usher in “a new era of economic growth.”

The Mexican action was endorsed by the Clinton Administration and the International Monetary Fund.

Stanley Fischer, IMF deputy director, called Mexico’s moves “an appropriate response to recent market developments. . . . These measures reinforce the sound economic policies that have been pursued in recent years and that resulted in a marked improvement in the performance of the Mexican economy.”

Despite the international praise and projections that Mexico’s long-term prospects remained solid, the net result was a day of trauma for the Mexican economy. The shock waves also rippled through Latin American markets, such as in Brazil, where the stock exchange finished down 6%.

Just hours after trading opened in Mexico City and in New York on Thursday morning, the peso took its largest drop against the dollar in more than a decade--free-falling from 3.978 at Wednesday’s close to 4.6, where Mexican economists said they expect it to remain for some time.

At the Bolsa, Mexico’s stock market, the peso float had the opposite effect. The market initially rallied, as the new exchange rate made Mexican stocks cheaper for foreign investors. Then, at midday, it plummeted. But then it rose again in the third heaviest trading day of the year, finishing up 4.66%, or 102.59 points.

But most Mexican stocks traded in the United States fell sharply. Shares in blue-chip Telefonos de Mexico, a key barometer for American investors who had viewed Mexico as a boom market for years, were down $4.25 at $40.75 after 14.77 million shares changed hands in extremely heavy trading.

“This is a tremendous blow to the Mexican economy,” said Mexican economist Rogelio Ramirez de la O. “I think it has inflicted tremendous wounds on Mexico. I think it will take six years to recover.

“The worst of the wounds is a crisis of confidence for President Zedillo,” he said. “It has exhibited a president who has lost control over the two most important policy initiatives in which we had so many hopes--the economic initiatives and the political initiatives in Chiapas.”

Serra’s announcement around midnight Wednesday that the peso would float came just 12 hours after he and Zedillo’s other key economic advisers had vowed that they would take no further action affecting the exchange rate, which fell 15% on Tuesday after the government lifted the Mexican currency’s official trading ceiling in response to a rebel mobilization in Chiapas.

Serra then flew on Thursday to New York, where he sought to explain the government’s actions to a high-powered group of federal officials and Wall Street representatives in a midday meeting at the Federal Reserve Bank of New York.

Bankers criticized the sudden reversal in policies and asked Serra why they should have confidence now in any other measures Mexico plans, according to one person at the meeting.

Serra told the 70 people assembled that the Mexican central bank will implement a tight monetary policy aimed at price stability, which will “entail an initial period of higher interest rates that will help stabilize the foreign exchange market.”

Serra also reiterated the government’s intent to contain inflation, balance its budget in 1995 and increase revenue through more sales of state-owned companies.

Most independent financial analysts agreed with Zedillo’s prediction that the devaluation will ultimately strengthen the economy by boosting exports. Economists stressed that some form of devaluation was necessary to adjust for Mexico’s trade deficit and to make its markets more competitive.

Former President Carlos Salinas de Gortari, whose sweeping free market reforms freed Mexico from its financial crises of the 1980s, stubbornly resisted a peso devaluation; such an action has become almost traditional in the Mexican presidential succession, usually occurring in the final months of a term.

But in the words of several economists, Salinas this time “left Zedillo holding the bag.”

Analysts also predicted that Zedillo’s radical steps may send Mexican inflation soaring far beyond the 4% that the government projected last week in its budget statement for 1995. They said the rates could go into the double-digit levels that plagued Mexico in the years before Salinas brought inflation under control.

In an effort to stave off such problems, the government announced an agreement Thursday with major employers and unions to freeze wages and prices for 60 days.

Still, most economists questioned Zedillo’s timing and methods to resolve the problem of the peso’s overvaluation.

“I think Salinas left basically a good situation behind,” Ramirez said. “I don’t think the economy was falling apart, and I don’t think it’s fair to blame Salinas. Even if we had to devalue--and for some time the Mexican government decided to ignore the signals--it didn’t have to be done this way. There were many other mechanisms in place. What we have seen is mismanagement. It’s very bad timing, extremely poor judgment and also some bad luck.”

But Ramirez said he does not expect a jump in inflation. The reason: Few Mexicans have enough money to fuel it.

“Last night, I got in a taxi from the airport, and after some time I asked the driver, ‘Why is the city so sad? It’s only a few days before Christmas,’ ” the economist recalled. “He said to me, ‘You know, people have no money.’ So I don’t think inflation will be a problem.”

Times staff writer Chris Kraul in San Diego contributed to this report.

* FINANCIAL IMPACT: How tumult affects business, consumers, workers. D1, D3.