The Mexican peso crisis, also known as the Tequila Crisis, was a currency crisis sparked by the sudden devaluation of the Mexican peso against the U.S. dollar in December 1994. This financial crisis led to an economic recession and widespread financial turmoil in Mexico that had significant impacts on Latin America and the world.

Introduction

In the early 1990s, Mexico appeared to be emerging as a major player on the world economic stage. It had transitioned to a liberalized market economy, joined the North American Free Trade Agreement (NAFTA), and was experiencing strong capital inflows and economic growth. However, in spite of the optimism, serious problems were brewing under the surface.

Mexico’s growth was financed by massive capital inflows, both from private investors and institutions like the IMF and World Bank. Much of this financing came in the form of portfolio investments rather than foreign direct investments. This made the economy vulnerable, as portfolio funds could be withdrawn quickly.

At the same time, Mexico’s current account deficit was growing rapidly. The fixed exchange rate regime, along with liberalized banking regulations, enabled excessive private sector borrowing without sufficient oversight. Much of Mexico’s borrowing was concentrated in short-term, dollar-denominated bonds. So when the peso crashed, many Mexican companies struggled to pay back their dollar debts.

The crisis exposed weaknesses in Mexico’s economic policies, as well as broader issues with capital account liberalization. It remains an important case study of emerging market financial crises to this day.

Background

In the late 1980s, Mexico began shifting toward a neoliberal economic model championed by its Harvard-educated Finance Minister Carlos Salinas de Gortari. Restrictions on foreign investments were eased, state-owned enterprises privatized, and capital markets deregulated.

Mexico also joined NAFTA in 1994, lowering trade barriers with the massive U.S. economy. These reforms attracted a surge of foreign capital, as investors were optimistic about Mexico’s prospects.

GDP growth averaged over 3% from 1988-1994. Inflation fell from 160% in 1987 to 7% by 1994. The influx of investment drove up wages and standards of living for many Mexicans. By 1994, some were describing Mexico as a “newly industrialized country”.

However, there were issues bubbling under the surface:

  • Overvalued exchange rate – The peso was pegged at 3.4 MXN/USD. Maintaining this rate became increasingly expensive as inflation diverged between Mexico and the U.S. It led to an overvalued currency.
  • Current account deficit – By 1993, Mexico’s current account deficit had ballooned to 8% of GDP. It was funded primarily through portfolio investments rather than FDI.
  • Short-term debt – Mexican firms and government borrowed heavily in short-term USD-denominated bonds, totalling over $100 billion by 1994. This created massive currency and maturity mismatches.
  • Weak banking system – Mexican banks engaged in risky lending with little oversight, since regulations had been loosened. Nonperforming loans were estimated at 10-15% of total lending.

These vulnerabilities set the stage for crisis when several tipping points hit in 1994.

Sparking the Crisis

By early 1994, increasing current account deficits, lower privatization revenues, and higher interest rates in the U.S. made Mexican assets less appealing to foreign investors. The assassination of presidential candidate Luis Donaldo Colosio in March further increased political uncertainty.

As a result, capital inflows slowed down through the year, putting pressure on the peso. Mexico’s central bank intervened to maintain the 3.4 peg, spending billions of its foreign currency reserves.

Collapse of the Peg

In December, with foreign reserves falling rapidly, newly inaugurated President Ernesto Zedillo announced that Mexico would let the peso float against the dollar. The central bank widened the band to 4 MXN/USD.

But speculative attacks continued and the peso kept weakening. On December 20, the band was expanded again to 15 MXN/USD and then just abandoned completely.

Over the next days, the peso lost nearly half its value. From its pre-crisis peg around 3.4, by January 1995 it was trading at 7.2 to the dollar.

Soaring Interest Rates

To stem the peso’s slide and control inflation, Mexico’s central bank sharply hiked interest rates. Rates exceeded 70% in March 1995.

While the rate hikes did stabilize the currency, they also choked off credit access and crippled many businesses.

Economic Fallout

The sudden 50% devaluation had severe economic consequences, resulting in a severe recession:

  • Stock market collapsed – The Mexican stock index plunged over 50% in dollar terms. Wealth was wiped out.
  • GDP contracted sharply – Mexico’s GDP shrank by 6.2% in 1995. Unemployment spiked, incomes fell, and 34% of Mexicans fell into poverty.
  • Banking crisis – Many banks and mortgage lenders went bankrupt due to bad debts and balance sheet mismatches. Nonperforming loans hit 25-30%. The government had to nationalize and recapitalize several banks.
  • Corporate bankruptcies – Mexican firms with significant USD debts suddenly found their peso revenues insufficient to service that debt. Defaults were widespread.
  • Capital flight – Foreign investors fled Mexico, worsening the credit crunch. Portfolio investments fell over 50% in 1995.
  • Bailout required – In January 1995, the IMF, U.S., and Canadian central banks announced a $50 billion support package for Mexico ($17.8 billion from the U.S.). This helped Mexico meet its external obligations.

The economy began recovering in 1996, but effects of the crisis lingered for years. Poverty rose, wages stagnated, and confidence in the economy was shattered.

Why Was Mexico Vulnerable?

With hindsight, several factors made Mexico’s economy prone to crisis:

Reliance on Portfolio Flows

Mexico depended too heavily on ‘hot money’ portfolio investments rather than long-term FDI. Portfolio flows are quick to enter and exit, whereas FDI is more ‘sticky’. As risk perceptions changed, investors rapidly pulled out their portfolio capital.

Short-Term Debt

Borrowing in short-term, dollar-denominated debt was dangerous with a fixed exchange rate. The central bank did not have enough reserves to repay or roll-over all of these obligations when they came due.

Weak Banking Regulation

Lax rules enabled reckless lending. Banks had insufficient capital buffers when bad debts mounted. Dollar-denominated debts also created mismatches on bank balance sheets.

Overvalued Currency

Maintaining the peso-dollar peg necessitated heavy forex market interventions by 1994, draining reserves. Letting the currency float earlier may have led to a more gradual devaluation.

Current Account Deficits

Relying on foreign borrowing to finance consumption and investment meant Mexico’s economy was living beyond its means. The country was consuming more than it was producing.

Political Shocks

Assassinations and electoral uncertainty in 1994 undermined investor confidence in Mexico’s political stability. This accelerated capital flight.

Contagion Through Latin America

The Tequila Crisis had pronounced contagion effects in emerging markets, especially Latin America:

  • Investors became risk averse to lending to developing countries, concerned that vulnerabilities in Mexico were present elsewhere.
  • Currencies and asset prices plunged throughout the region. Major devaluations occurred in Argentina, Brazil, Venezuela, Chile and other countries in 1995.
  • GDP growth slowed markedly in Latin America. Venezuela and Argentina experienced outright recessions.

Countries that had inflation targeting regimes, flexible exchange rates, and lower foreign-currency debts were less severely impacted. But global investor sentiment toward emerging markets deteriorated in what came to be called the first modern EM financial crisis.

Lessons Learned

The Mexican Peso Crisis highlighted inherent risks with liberalized capital accounts, especially for emerging economies. Key lessons included:

  • Managing booms – Large capital inflows need to be carefully regulated to prevent excessive borrowing and currency overvaluation.
  • Current account risks – Persistent current account deficits financed by portfolio flows are hazardous. Policymakers should focus on improving trade competitiveness.
  • Banking regulation – Reckless bank lending needs to be deterred even in liberalized systems. Banks need sufficient capital and provisions.
  • Flexible exchange rates – Fixed pegs are vulnerable to speculative attacks. More flexibility reduces this exposure.
  • Reducing USD debts – Corporations and banks should be encouraged to borrow in local currency terms whenever possible. Regulations can help.
  • Contingency planning – Authorities need to prepare contingency plans in case of sudden stops or reversals in capital flows. Stockpiling reserves helps manage crises.
  • IMF reforms – The IMF came under criticism for encouraging unsustainable policies in Mexico. Reforms improved conditionality on IMF programs.

Overall, the Tequila Crisis was a painful lesson on the risks of financial globalization and the need for prudential oversight even in liberalized markets. These lessons proved valuable for emerging markets in subsequent crises.

Conclusion

The 1994 Mexican Peso Crisis was a formative event for emerging market financial systems. Mexico’s rapid liberalization and deregulation attracted massive capital inflows, but also enabled excessive borrowing. When investor sentiment turned, Mexico experienced a severe currency crash, financial crisis, and economic recession.

The crisis highlighted the dangers of relying on short-term portfolio flows to finance current account deficits. It showed how financial liberalization requires commensurate monitoring of lending and exchange rate risks. It also demonstrated the dire impacts of currency mismatches in developing countries.

Mexico eventually enacted reforms to strengthen its policy frameworks, leading to a stronger economy in the long run. But the Tequila Crisis remains a cautionary example of how emerging markets need to exercise prudence even during periods of exceptional growth. The perils of financial crises are simply too great.