This paper proposes a simple investment model that permits a test of the relative importance of Mexico's terms of trade decline, the reversal in net capital inflows, and the debt overhang, in explaining Mexico's investment decline in the early 1980's. The paper uses previously unexploited sectoral investment data between 1981 and 1985 to estimate the quantitative importance of these explanations. The data indicate that the main microeconomic mechanism driving the investment decline was the rise in the relative price of investment goods, and further that the deterioration in Mexico's international terms of trade explains most of the increase in this relative price. Our preferred estimate is that about two-thirds of the investment decline was attributable to the terms of trade decline, while the termination of capital inflows explains the remaining third. The paper finds little evidence in favor of other debt crisis effects such as the debt-overhang effect or several other more subtle effects that have been proposed in the literature.

This paper proposes a simple investment model that permits a test of the relative importance of Mexico's terms of trade decline, the reversal in net capital inflows, and the debt overhang, in explaining Mexico's investment decline in the early 1980's. The paper uses previously unexploited sectoral investment data between 1981 and 1985 to estimate the quantitative importance of these explanations. The data indicate that the main microeconomic mechanism driving the investment decline was the rise in the relative price of investment goods, and further that the deterioration in Mexico's international terms of trade explains most of the increase in this relative price. Our preferred estimate is that about two-thirds of the investment decline was attributable to the terms of trade decline, while the termination of capital inflows explains the remaining third. The paper finds little evidence in favor of other debt crisis effects such as the debt-overhang effect or several other more subtle effects that have been proposed in the literature.

Sorting out the role of the decline in the price of oil versus the debt crisis is important because many continue to debate the merits of debt relief and some argue that relief is a necessary condition for an investment rebound in heavily indebted less developed countries. There is relatively little empirical work estimating the magnitude of the effect of the debt crisis on investment after controlling for other determinants of investment, and there is a more general lack of empirical studies on investment determination in small open economies like Mexico.

This paper addresses these issues by using data from a sector-level investment survey conducted in Mexico between the first quarter of 1981 and the last quarter of 1985, which has not yet received much attention. We propose and estimate an investment model that can discriminate between the oil price decline and several other debt crisis effects.

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