The 1994 Mexican Peso Crisis

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Edwin Gutierrez is head of emerging-markets sovereign debt at Aberdeen Asset Management in London.

https://www.institutionalinvestor.com/article/b14zbgc6dr9wlw/how-mexico-shook-off-the-tequila-crisis

The Tequila crisis in 1994-- Economic Report

September 19, 2013, by Maarten van der Molen

https://economics.rabobank.com/publications/2013/september/the-tequila-crisis-in-1994/

Steward Investor

https://www.stewartinvestors.com/en/education/lessons-from-the-past---the-tequila-crisis/

The Tequila or Mexican Peso Crisis is a financial disaster causing a sudden devaluation of the Mexican peso which caused other currencies in Latin America (such as in the Southern Cone and Brazil) to decline as well.

An examination of the reasons for this crisis provides a number of lessons for equity investors today.

 One of the biggest takeaways from the Tequila Crisis, which kicked off when the Mexican peso was suddenly devalued against the U.S. dollar, was the importance of issuing peso-denominated debt (debt denominated in your own country’s currency).

Summary

A key cause in the crisis was the decision to issue short-term debt in dollars, which came due very quickly and cost the country dearly when the value of the peso plummeted. 

When the so-called Tequila Crisis dealt Mexico, the mother of all economic hangovers 20 years ago— the country was ill prepared for the consequences.

The early 1990's  saw a lending boom in Mexico. Bank liberalization encouraged excessive risk-taking by banks with expansion into consumer loans and mortgages, as well as borrowing in US dollars. After years of strong returns for equity investors, the Mexican currency and stock market crashed in 1994. Interest rates rose steeply during the crisis and pushed the economy into deep recession.

A spike in risk aversion, caused by political instability and rising US interest rates, resulted in capital flight from Mexico and pressure on the peso. On one single day, 18 November 1994, $1.6bn left the country, with $3bn departing over the month. In four weeks Mexico lost $11 billion in reserves. Pressure on the peg intensified to a critical level. Initially the central bank widened the trading band, but this had little impact.

On 20 December, the Mexican government devalued the peso by 15%, but capital continued to leave the country. Between 20 and 21 December, $4.6bn left Mexico, almost half the remaining foreign exchange reserves.

On December 20, 1994, the Mexican central bank devalued the peso between 13 to 15%. To limit the excessive flight of capital, the bank also raised interest rates. Short-term interest rates rose to 32%, and the resulting higher costs of borrowing were a danger to economic stability.

On 22 December, Banco de Mexico withdrew from the foreign exchange market, allowing the peso to float. The Mexican stock market dropped two-thirds in dollar terms between 19 December 1994 and 9 March 1995 when it bottomed. Contagion spread to other emerging stock markets, particularly Brazil and Argentina, which fell steeply, raising concerns about a broader emerging market crisis.

The Mexican government allowed the peso to float freely again two days later, but rather than stabilize, the peso took another sharp hit, depreciating nearly into half of its value in the months that would follow.

Immediately after the Mexican peso was devalued, in the early days of the Presidency of Ernesto Zedillo-- South American countries suffered from rapid currency depreciation and a loss of reserves. Foreign capital not only fled Mexico but the crisis led to financial contagion in emerging markets as well.

It was a known fact that the peso was overvalued, but the extent of Mexico's economic vulnerability was not well known. Since governments and businesses in the area had high levels of U.S. dollar-denominated debt, the devaluation meant that it would be increasingly difficult to pay back the debts.

In 1995, GDP shrank by 6.2% and real wages fell by about 20% in the wake of the crisis. Bank defaults spiked, causing the worst banking crisis in Mexican history (1995-7).

Ultimately, new banking legislation introduced in 1997 allowed foreign investors to gain control of Mexican banks. By 2008, foreign banks controlled 80% of the assets in the commercial banking system.

In many ways the Tequila Crisis is a classic example of an emerging market boom and bust, highlighting the susceptibility of countries to capital flows and the risks of foreign currency debt under a fixed exchange-rate regime.

Yet a country has rarely shaken off a financial downturn as quickly and as effectively as did Mexico. The falling peso was eventually propped up by a $50-billion bailout package coordinated by then U.S. President Bill Clinton and administered by the International Monetary Fund (IMF).

On 11 January 1995, President Clinton announced financial support for Mexico. A credit line of $50bn was established with the US Treasury providing $20bn, the International Monetary Fund $18bn, the Bank of International Settlements $10bn and private banks the rest. This helped Mexico avoid a sovereign default and marked the beginning of a return to financial stability, underpinned by further financial reforms in March 1995 as part of a stabilization plan.

In response to the crisis, the U.S. Congress passed the Mexican Debt Disclosure Act of 1995, on April 10, 1995, which was enacted by President Clinton. The law provided billions in financial assistance for swap facilities and securities guarantees using American taxpayer dollars, and additional assistance provided by the IMF.

The Mexican government—as a condition of the sizable bailout—was required to implement certain fiscal and monetary policies controls. They were also careful to maintain their existing commitments to policies of the North American Free Trade Agreement (NAFTA).

Mexico suffered through a severe recession and bouts of hyperinflation in the years following the crisis, as the country maintained excessive levels of poverty for the remainder of the nineties.

Although Mexico is now partway through a cyclical slowdown, per capita gross domestic product has nearly tripled since the trough of 1995, inflation is manageable, and the country’s ratio of debt to gross domestic product is less than 37%. (By comparison, Japan’s is more than 225%). It is remarkable what effect two decades, some painful lessons and sensible policymakers can have.

Mexico’s mistakes, and the lessons it has learned, have been shared throughout the emerging-markets economies. Most fixed exchange rates have been replaced by floating systems.

Mexican issues are now largely in the domestic currency, which avoids foreign exchange risk. The terms of Mexico’s debt tend to be much longer with more time for repayment.

Local currency debt is the fastest-growing segment of the emerging-markets debt asset class. In the buildup to the Tequila Crisis, Mexico was issuing debt with a term of 28 days. Nowadays, the average duration of the local currency debt index is about seven years. In other words, issuers are trying to avoid the peril that befell Mexico.

The Crisis examined in Detail

Precursors

After financial problems in the early 1980's, Mexico introduced economic reforms in the second half of the decade. Trade was liberalized by a rapid reduction of tariffs, and the banking sector was deregulated and privatized. The budget deficit fell, inflation declined and the economy boomed.

In the early 1990's, Mexico had woefully inadequate foreign exchange reserves, which were promptly swallowed up in the peso’s tailspin. When the coffers ran dry, the U.S. was forced to step in with a bailout. Mexico has since replenished its reserve currency stockpile, growing it from a low of nearly $6 billion in 1994 to about $180 billion today. These reserves are Mexico’s way of saving for a rainy day and providing insulation for when the economy turns.

In 1991 the Bank of Mexico effectively fixed the exchange rate by allowing the peso to move within a short range against the dollar. This arrangement would be abandoned by the end of 1994 as a series of events pushed the dollar peg to the breaking point. The Federal Reserve raised rates in February of that year, and a number of subsequent domestic events caused investors to steadily lose faith in Mexico’s ability to finance its current-account deficit and triggered a full-blown rout of the peso. Mexico has maintained a floating-rate mechanism ever since, which acts as a shock absorber as confidence ebbs and flows.

 This buoyant period culminated in the conclusion of the North American Free Trade Agreement (NAFTA), which eliminated most tariffs between Canada, Mexico and the US, and came into effect in January 1994.

As a result of the positive economic environment in Mexico, foreign capital flooded into the stock market which provided very high returns for investors year after year, including a rise of 118% in 1991.

Exchange rate policy

Mexico had a history of balance of payment crises -  the depreciation of the peso in 1954, 1976 and 1982. 

As a result of the reform program of the 1980's, the currency was pegged to the US dollar; a crawling peg allowing gradual depreciation, although in real terms the peso appreciated. 

This policy caused rigidity, however, especially as the economy boomed and sucked in imports, causing the current account deficit to rise from $2.4bn in 1988 to $29.4bn in 1994. This left the country susceptible to short-term capital flows.

US interest rates

An important factor precipitating the crisis was a series of US interest rate rises, month after month, in 1994. The pace of the tightening caught the market by surprise and resulted in strengthening of the US dollar, which put severe pressure on currencies like the peso, which were linked to it.

Political instability

1994 proved to be a year of political upheaval in Mexico. On 1 January, the Zapatista National Liberation Army launched a rebellion against the government in the southern state of Chiapas, with violence continuing throughout the year. On 23 March, Luis Donaldo Colosio, the ruling Institutional Revolutionary Party’s (PRI) presidential candidate, was assassinated.

A wave of kidnappings of Mexican entrepreneurs occurred between March and September. In late September, Jose Massieu, the Secretary General of the PRI was also assassinated. On 23 November, the Deputy Attorney General resigned, alleging a cover-up of the murder of his brother Massieu, which intensified the financial crisis.

Monument to Luis Donaldo Colosio in Mexico City's Paseo de la Reforma.

With 1994 being the final year of his administration's sexenio (the country's six-year executive term limit), then-President Carlos Salinas de Gortari endorsed Luis Donaldo Colosio as the Institutional Revolutionary Party's (PRI) presidential candidate for the Mexico's 1994 general election.

In accordance with party tradition during election years, Salinas de Gortari began an unrecorded spending spree. Mexico's current account deficit grew to roughly 7% of GDP that same year, and Salinas de Gortari allowed the Secretariat of Finance and Public Credit, Mexico's treasury, to issue short-term peso-denominated treasury bills with a guaranteed repayment denominated in U.S. dollars, called "tesobonos". These bills offered a lower yield than Mexico's traditional peso-denominated treasury bills, called "cetes", but their dollar-denominated returns were more attractive to foreign investors.

Zapatista Army of National Liberation (EZLN) insurgents in Mexico.

Investor confidence rose after the North American Free Trade Agreement (NAFTA) was signed. Upon NAFTA's entry into force on January 1, 1994, Mexican businesses as well as the Mexican government enjoyed access to new foreign capital thanks to foreign investors eager to lend more money. International perceptions of Mexico's political risk began to shift, however, when the Zapatista Army of National Liberation declared war on the Mexican government and began a violent insurrection in Chiapas.

Investors further questioned Mexico's political uncertainties and stability when PRI presidential candidate Luis Donaldo Colosio was assassinated while campaigning in Tijuana in March 1994, and began setting higher risk premium on Mexican financial assets. Higher risk premium initially had no effect on the peso's value because Mexico had a fixed-exchange rate.

Mexico's central bank, Banco de México, maintained the peso's value through an exchange rate peg to the U.S. dollar, allowing the peso to appreciate or depreciate against the dollar within a narrow band. To accomplish this, the central bank would frequently intervene in the open markets and buy or sell pesos to maintain the peg.

The central bank's intervention strategy partly involved issuing new short-term public debt instruments denominated in U.S. dollars. They then used the borrowed dollar capital to purchase pesos in the foreign exchange market, which, in turn, caused the peso to appreciate. The bank's purpose in mitigating the peso's depreciation was to protect against inflationary risks of having a markedly weaker domestic currency, but with the peso stronger than it ought to have been, domestic businesses and consumers began purchasing increasingly more imports, and Mexico began running a large trade deficit. Speculators began recognizing that the peso was artificially overvalued and led to speculative capital flight that further reinforced downward market pressure on the peso.

Mexico's central bank deviated from standard central banking policy when it fixed the peso to the dollar in 1988. Instead of allowing its monetary base to contract and its interest rates to rise, the central bank purchased treasury bills to prop up its monetary base and prevent rising interest rates—especially given that 1994 was an election year. Additionally, servicing the tesobonos with U.S. dollar repayments further drew down the central bank's foreign exchange reserves.

 Consistent with the macroeconomic trilemma in which a country with a fixed exchange rate and free flow of financial capital sacrifices monetary policy autonomy, the central bank's interventions to revalue the peso caused Mexico's money supply to contract (without an exchange rate peg, the currency would have been allowed to depreciate). The central bank's foreign exchange reserves began to dwindle and it completely ran out of U.S. dollars in December 1994.

In the second half of the 20th century, Mexico was confronted with multiple economic crises. In this Special we focus on the crisis of 1994, where a strong devaluation of the peso led to both a currency and banking crisis. A sovereign crisis was just prevented. Next to explaining how the crisis evolved, we describe the economic background and triggers of the crisis.

After 1982: liberalizing the economy

In the years after the sovereign debt and balance of payment crisis of 1982 (See Special Report 2013/14: The Mexican 1982 debt crisis), the Mexican government shifted to a more market orientated economic model. The policy shift led to the privatization of government-owned enterprises, the deregulation of industries, and the reduction of trade barriers. In addition, restrictions on foreign investment in many sectors were lifted. 

1989: Final deal and more liberalization

In 1989, the government agreed on the “Brady plan”, legitimizing the concept of debt relief, a remainder of the 1982 crisis. Only then, did banks and companies regain the option to borrow in financial markets abroad. 

Furthermore, in anticipation of joining the North American Free Trade Agreement (NAFTA) in 1994, Mexico started to further open up its economy. Mexico had to do so, as the free transfer of funds was a core principal of US treaties, including NAFTA. Next to a further trade liberalization for both goods and services, Mexico eliminated most capital and exchange controls. This paved the way for foreign investment in; securities, loans, direct investment, bonds (sovereign and private) and derivatives (Nordgaard, 2013). 

There is one exception: a currency pact

Part of the reform agenda was the introduction of a crawling peg to the US dollar in November 1991. Since then, the peso was allowed to float within a constant lower band and a slowly increasing upper band, therefore, a gradual depreciation was allowed. The pact served at least three purposes. First, it gave foreign investors additional assurance, as the risks of currency fluctuations were limited. Second, it allowed Mexican companies to borrow money in international markets to finance their expansion. Third, a managed exchange rate would help Mexico to fight domestic inflation (Musacchio, 2012).

Reforms in the financial sector…

After the nationalization of almost all private banks in 1982, Mexico privatized them again in 1991-92. However, at that time the banking sector could be characterized as highly concentrated, with loans being primarily provided on the basis on political priorities rather than on credit worthiness.  

The privatization process itself caused skepticism. First, the government was mainly focused on maximizing the sales price, with the restriction that foreign banks could not participate in the bidding process. To drive up the sales price the buyers were given considerable privileges: the four banks controlled 70% of all bank assets and the sector was almost closed to foreign competition. 

Second, the bidders’ experience in the banking sector was not taken into account. Third, the Mexican government delayed the implementation of international banking standards. And according to the old standard, after the maturity of a non-performing loan (NPL) expired, only the interest rate payments were reported as non-performing, while the principal was reported as performing. This led to a strong overestimation of the value of the banks. 

Another important feature of the banking sector was that the regulator was inexperienced in monitoring the banks. And depositors had no incentive to monitor the banks, as the Mexican government guaranteed both deposits and liabilities (Musacchio, 2012). 

… leading to a credit boom

After the privatization of the banks, Mexico experienced an enormous credit boom, as all banks competed strongly to gain more market share to earn back their investments (table 2). This credit expansion later turned out fatal, as the performance of the existing portfolio was worse than expected. In addition, new loans were of poor quality due to this rapid expansion. Finally, banks borrowed in dollars to finance their expansion (Musacchio, 2012). 

Table 2: Performance of the banking sector

Source: Haber (2005)

  

Triggers for the crisis of 1994

It is impossible to just point at one trend or event to explain the Mexican crisis. Below we will discuss the triggers, which in our view, played an important role:

1) The liberalization of the financial account allowed money to flow freely in and out of Mexico.

2) The low policy rate set by FED at the beginning of the ’90, led to a search by investors for higher yields. Mexico, which was fighting inflation, had a relatively high policy rate, making it attractive for foreign investment. This resulted in a strong increase of portfolio investment. In 1994, the FED raised its policy rate, causing a lower spread, as Mexico’s central bank did not follow. The result was a strong decline in portfolio investment. 

3) Until 1994, Mexico was running a current account deficit, which was compensated by the financial account. However, a sudden stop of the inflow of portfolio investment in March/ April, led to a considerable depletion of the foreign exchange reserves.

4) To stop the outflow of foreign currency in March 1994, Mexico’s government started to issue short term dollar denominated debt, called tesobonos. By November 1994, 70% of foreign holdings was dollar denominated. The deterioration of the ratio of foreign exchange reserves to foreign denominated debt (with a short maturity) started to concern investors.

5) In the year prior to the crisis, Mexico’s was confronted by social unrest. Two political leaders were assassinated, while the province of Chiapas was confronted with violence. In addition, there were doubts about the fairness of the presidential elections of 1994.

Figure 1: Exchange rate

Source: Banco de Mexico

Evolution of a crisis

March - November, 1994
The crawling peg of the Mexican peso (figure 1) is under fire. Not only does the US Federal Reserve raise its policy rate by 250bps during this time span, Mexico also suffers from political homocides in the lead-up to the presidential elections later that year. Foreign exchange reserves therefore decline rapidly (figure 3).

In April, to stop the outflow of foreign currency, the Mexican government issues short term dollar denominated debt, called tesobonos. As investors buying the tesobonos are protected for a potential devaluation of the peso, the outflow of foreign currency stops, while the foreign exchange rate stabilizes. However, in November USD 3bn is pulled out of the country, of which USD 1.6bn on a single day (18 November).

December 1^st, 1994
The new Mexican government, headed by President Zedillo, takes office.

December 15^th, 1994
The Wall Street Journal publishes an interview with the new Finance Minister Jaime Serra Puche, in which he denies that Mexico will devaluate the peso. The next day, USD 855 m leaves Mexico.

December 20^th, 1994
The new cabinet concludes that the situation is unsustainable. Therefore, the Central Bank of Mexico announces a lift of the upper band of the exchange rate by 15%, an effective devaluation of the peso.

December 20-21^th, 1994
In the two days after the announcement, USD 4.6 bn leaves the country, half of the foreign exchange reserves.

December 22th, 1994
The intervention on the foreign exchange market is lifted, and the peso is allowed to float freely. The total devaluation of the peso amounts to 35% by the end of December.

    

Figure 2: Financial account Mexico

Source: Banco de Mexico

Figure 3: Foreign reserves

Source: Banco de Mexico, Macrobond

Impact on the banking sector

As explained above, Mexico’s banking system was already in a bad shape prior to the crisis, and the events in December were according to Haber (2005), just a tipping point. 

The devaluation of the peso and the strong rise of inflation, resulted in an interest rate hike. A majority of the banks’ debtors were unable to pay the higher interest rates, which led to a strong rise of the NPL ratio. Banks were therefore unable to honor their foreign currency liabilities. To prevent a systemic banking crisis, the government implemented a bailout program:

1) Providing dollar liquidity to the banks.

2) Allowing banks to transfer part of their ‘bad’ portfolio to the government, including NPL’s.

3) Recapitalizing all banks, that did not have a minimal capital ratio of 8%.

4) The debt burden of borrowers was relieved. Loans could be converted to a CPI-index unit, whereby debtors paid a real interest of 4% plus a premium, which reflected the credit risk.

Due to the measures, a collapse of the banking sector was prevented and no obligatory write-offs took place. It would however, take years for the banking sector to recover (table 2). As a consequence of illness of the banking sector, new credit was almost not available, exacerbating the economic crisis (Krueger and Tornell, 1999). 

  

Mexican peso crisis

The Mexican peso crisis was a currency crisis sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994, which became one of the first international financial crises ignited by capital flight.

During the 1994 presidential election, the incumbent administration embarked on expansionary fiscal and monetary policy. The Mexican treasury began issuing short-term debt instruments denominated in domestic currency with a guaranteed repayment in U.S. dollars, attracting foreign investors. 

Mexico enjoyed investor confidence and new access to international capital following its signing of the North American Free Trade Agreement (NAFTA). However, a violent uprising in the state of Chiapas, as well as the assassination of the presidential candidate Luis Donaldo Colosio, resulted in political instability, causing investors to place an increased risk premium on Mexican assets.

In response, the Mexican central bank intervened in the foreign exchange markets to maintain the Mexican peso's peg to the U.S. dollar by issuing dollar-denominated public debt to buy pesos. The peso's strength caused demand for imports to increase in Mexico, resulting in a trade deficit. 

Speculators recognized an overvalued peso and capital began flowing out of Mexico to the United States, increasing downward market pressure on the peso. Under election pressures, Mexico purchased its own treasury securities to maintain its money supply and avert rising interest rates, drawing down the bank's dollar reserves. Supporting the money supply by buying more dollar-denominated debt while simultaneously honoring such debt depleted the bank's reserves by the end of 1994.

The central bank devalued the peso on December 20, 1994, and foreign investors' fear led to an even higher risk premium. To discourage the resulting capital flight, the bank raised interest rates, but higher costs of borrowing merely hurt economic growth. Unable to sell new issues of public debt or efficiently purchase dollars with devalued pesos, Mexico faced a default. Two days later, the bank allowed the peso to float freely, after which it continued to depreciate. 

The Mexican economy experienced inflation of around 52% and mutual funds began liquidating Mexican assets as well as emerging market assets in general. The effects spread to economies in Asia and the rest of Latin America. The United States organized a $50 billion bailout for Mexico in January 1995, administered by the International Monetary Fund (IMF) with the support of the G7 and Bank for International Settlements. In the aftermath of the crisis, several of Mexico's banks collapsed amidst widespread mortgage defaults. The Mexican economy experienced a severe recession and poverty and unemployment increased.

Crisis

On December 20, 1994, newly inaugurated President Ernesto Zedillo announced the Mexican central bank's devaluation of the peso between 13% and 15%.Devaluing the peso after previous promises not to do so led investors to be skeptical of policymakers and fearful of additional devaluations. Investors flocked to foreign investments and placed even higher risk premium on domestic assets. 

This increase in risk premium placed additional upward market pressure on Mexican interest rates as well as downward market pressure on the Mexican peso. Foreign investors anticipating further currency devaluations began rapidly withdrawing capital from Mexican investments and selling off shares of stock as the Mexican Stock Exchange plummeted. To discourage such capital flight, particularly from debt instruments, the Mexican central bank raised interest rates, but higher borrowing costs ultimately hindered economic growth prospects.

When the time came for Mexico to roll over its maturing debt obligations, few investors were interested in purchasing new debt. To repay tesobonos, the central bank had little choice but to purchase dollars with its severely weakened pesos, which proved extremely expensive. The Mexican government faced an imminent sovereign default.

On December 22, the Mexican government allowed the peso to float, after which the peso depreciated another 15%.The value of the Mexican peso depreciated roughly 50% from 3.4 MXN/USD to 7.2, recovering only to 5.8 MXN/USD four months later. Prices in Mexico rose by 24% over the same four months, and by the end of 1995 Mexico's inflation had reached Mutual funds, which had invested in over $45 billion worth of Mexican assets in the several years leading up to the crisis, began liquidating their positions in Mexico and other developing countries.

 Foreign investors not only fled Mexico but emerging markets in general, and the crisis led to financial contagion throughout other financial markets in Asia and Latin America. The impact of Mexico's crisis on the Southern Cone and Brazil became known as the "Tequila effect" (Spanish: efecto tequila).

January 26th, 1995 

The IMF announces a rescue package of USD 7.8 bn.

January 31th, 1995
The US announces a USD 50 bn rescue package for Mexico, consisting of USD 20 bn from the US, USD 18 bn from the IMF (including the USD 7.8 billion already announced on January 26^th), USD 10 bn from the Bank for International Settlements, and USD 3 bn from private commercial banks (Musacchio, 2012). Due to the credit line, Mexico is able to roll over its short term dollar denominated debt, although at considerable higher yields. Without the help Mexico probably would have defaulted on its tesobonos.

Early March, 1995
Mexican government announces a stringent austerity package, leading to renewed confidence by investors. (Whitt, 1996)

Impact on the economy

Just after the devaluation of the peso, Mexico’s economy started to rebalance (table 1). The process started by a considerable contraction of both private and government consumption, which helped Mexico to lower its import bill. This while Mexico’s export sector was given a boost, thanks to the devaluation of the peso.

The process of re-balancing proceeded quite fast. In the first half of the year, Mexico’s economy contracted by 10%. In the three years thereafter, the economy recovered rather well, with an average growth rate of almost 6%. Moreover, the current account deficit declined from -5.8% in 1994 to -0.5% in 1995. Along with the fall in GDP, unemployment rose from 3.7% in 1994 to 6.2% in 1995. But, as with the overall economy, the situation on the labor market improved fast, showing a decline to 5.5% in 1996.

The story for inflation was different. Due to the devaluation of the peso, goods and services from abroad became more expensive, pushing up inflation. In addition, given Mexico’s history of high inflation, the expected inflation shot up as well, worsening the inflation outlook. It would take Mexico years before inflation was at an acceptable level again.

Table 1: Overview of economic indicators

Source: IMF

Bailout

See also: Mexican Debt Disclosure Act of 1995

In January 1995, U.S. President Bill Clinton held a meeting with newly confirmed U.S. Treasury Secretary Robert Rubin, U.S. Federal Reserve Chairman Alan Greenspan and then-Under Secretary for the Treasury Larry Summers to discuss an American response. According to Summers' recollection of the meeting:

Secretary Rubin set the stage for it briefly. Then, as was his way, he turned to someone else, namely me, to explain the situation in more detail and our proposal. And I said that I felt that $25 billion was required, and one of the President’s political advisers said, “Larry, you mean $25 million.” And I said, “No, I mean $25 billion.” ... There was a certain pall over the room, and one of his [Clinton's] other political advisers said, “Mr. President, if you send that money to Mexico and it doesn’t come back before 1996, you won’t be coming back after 1996.”

Clinton decided nevertheless to seek Congressional approval for a bailout and began working with Summers to secure commitments from Congress.

Motivated to deter a potential surge in illegal immigration and to mitigate the spread of investors' lack of confidence in Mexico to other developing countries, the United States coordinated a $50 billion bailout package in January 1995, to be administered by the IMF with support from the G7 and the Bank for International Settlements (BIS). The package established loan guarantees for Mexican public debt aimed at alleviating its growing risk premium and boosting investor confidence in its economy. The Mexican economy experienced a severe recession and the peso's value deteriorated substantially despite the bailout's success in preventing a worse collapse. Growth did not resume until the late 1990's.

The conditionality of the bailout required the Mexican government to institute new monetary and fiscal policy controls, although the country refrained from balance of payments reforms such as trade protectionism and strict capital controls to avoid violating its commitments under NAFTA. The loan guarantees allowed Mexico to restructure its short-term public debt and improve market liquidity. Of the approximately $50 billion assembled in the bailout, $20 billion was contributed by the United States, $17.8 billion by the IMF, $10 billion by the BIS, $1 billion by a consortium of Latin American nations, and CAD$1 billion by Canada.

The Clinton administration's efforts to organize a bailout for Mexico were met with difficulty. It drew criticism from members of the U.S. Congress as well as scrutiny from the news media. The administration's position centered on three principal concerns: potential unemployment in the United States in the event Mexico would have to reduce its imports of U.S. goods (at the time, Mexico was the third-largest consumer of U.S. exports); political instability and violence in a neighboring country; and a potential surge in illegal immigration from Mexico.

 Some congressional representatives agreed with American economist and former Chairman of the Federal Deposit Insurance Corporation, L. William Seidman, that Mexico should just negotiate with creditors without involving the United States, especially in the interest of deterring moral hazard. On the other hand, supporters of U.S. involvement such as Fed Chair Alan Greenspan argued that the fallout from a Mexican sovereign default would be so devastating that it would far exceed the risks of moral hazard.

Following the U.S. Congress's failure to pass the Mexican Stabilization Act, the Clinton administration reluctantly approved an initially dismissed proposal to designate funds from the U.S. Treasury's Exchange Stabilization Fund as loan guarantees for Mexico. These loans returned a handsome profit of $600 million and were even repaid ahead of maturity. 

Then-U.S. Treasury Secretary Robert Rubin's appropriation of funds from the Exchange Stabilization Fund in support of the Mexican bailout was scrutinized by the United States House Committee on Financial Services, which expressed concern about a potential conflict of interest because Rubin had formerly served as co-chair of the board of directors of Goldman Sachs, which had a substantial share in distributing Mexican stocks and bonds.

Economic impacts

Mexico's economy experienced a severe recession as a result of the peso's devaluation and the flight to safer investments. The country's GDP declined by 6.2% over the course of 1995. Mexico's financial sector bore the brunt of the crisis as banks collapsed, revealing low-quality assets and fraudulent lending practices. Thousands of mortgages went into default as Mexican citizens struggled to keep pace with rising interest rates, resulting in widespread repossession of houses.

Construction workers working on a residential building in Tijuana, Mexico.

In addition to declining GDP growth, Mexico experienced severe inflation and extreme poverty skyrocketed as real wages plummeted and unemployment nearly doubled. Prices increased by 35% in 1995. Nominal wages were sustained, but real wages fell by 25-35% over the same year. Unemployment climbed to 7.4% in 1995 from its pre-crisis level of 3.9% in 1994. 

In the formal sector alone, over one million people lost their jobs and average real wages decreased by 13.5% throughout 1995. Overall household incomes plummeted by 30% in the same year. Mexico's extreme poverty grew to 37% in 1996 from 21% in 1994, undoing the previous ten years of successful poverty reduction initiatives. The nation's poverty levels would not begin returning to normal until 2001.

Mexico's growing poverty affected urban areas more intensely than rural areas, in part due to the urban population's sensitivity to labor market volatility and macroeconomic conditions. Urban citizens relied on a healthy labor market, access to credit, and consumer goods. Consumer price inflation and a tightening credit market during the crisis proved challenging for urban workers, while rural households shifted to subsistence agriculture. 

Mexico's gross income per capita decreased by only 17% in agriculture, contrasted with 48% in the financial sector and 35% in the construction and commerce industries. Average household consumption declined by 15% from 1995 to 1996 with a shift in composition toward essential goods. Households saved less and spent less on healthcare. Expatriates living abroad increased remittances to Mexico, evidenced by average net unilateral transfers doubling between 1994 and 1996.

Households' lower demand for primary healthcare led to a 7% hike in mortality rates among infants and children in 1996 (from 5% in 1995). Infant mortality increased until 1997, most dramatically in regions where women had to work as a result of economic need.

Critical scholars contend that the 1994 Mexican peso crisis exposed the problems of Mexico’s neo-liberal turn to the Washington consensus approach to development. Notably, the crisis revealed the problems of a privatized banking sector within a liberalized yet internationally subordinate economy that is dependent on foreign flows of finance capital.

Lessons from the crisis

How the crisis shaped Mexico is hard to tell, but there have been some structural breaks after the 1994 crisis.

• In July 1997, the PRI, the political party that had been in control of Mexican politics for almost 70 years, lost the mayoral election of Mexico City. In addition, the PRD took over control of Congress.
• In 2000, the PRI lost the presidential elections.
• The credit to GDP ratio is still low compared to international levels. This could have been caused by the bad shape of the banking sector after the crisis. Another explanation could be that Mexicans are still reserved to take loans.
• The Mexican peso remains freely floating, although during the Global Economic Crisis, measures were taken to prevent a large slide
• The central bank has built up an adequate stock of foreign exchange reserves, currently representing 4.8 months of imports.

Mexico Going Forward

The Tequila Crisis also shows the risks that banks take during a boom. Inherent systematic risk, leveraged financial structures and opacity, make banks particularly risky investments.

The Mexican Tequila Crisis was triggered by a combination of poorly carried out reforms, a currency peg, current account deficits, policy rate hikes in the US and social unrest, and finally led to both a currency and banking crisis. A sovereign crisis was just averted, due to financial assistance of among others the US and the IMF. The banking sector, which was already in a bad shape, would have collapsed without the help of the government.  

Two decades after the peso devaluation, the country is on a more solid footing and, under President Peña Nieto, looking ahead.

Recent reforms under President Enrique Peña Nieto may help prevent future crises. During his first 20 months in office, Peña Nieto proposed and saw passed 11 structural reforms, including in energy, financial services and education. This zeal for economic and financial overhaul sets Mexico apart. Often, emerging markets wait until crises happen before making reforms, spooking investors and forcing policymakers into taking knee-jerk measures.

On a macro level, these changes should have a meaningful impact on consumer price inflation and make some headway toward Mexico’s ambitious 3 percent inflation target. They do not, however, hide the toxic combination of corruption and the inability of the Mexican government to enforce the rule of law.

There is no better example than the abduction and execution of 43 students in September on the alleged orders of a mayor in Guerrero state. Time is not on Peña Nieto’s side to fight this particular war; however, so far his plans bode well for Mexico in the long term. His energy reforms, for example, will not be fully realized for at least a decade, long after he has left office.

 Breaking down Mexico’s oligopolies will actually harm the country’s stock exchange in the short term, as new competition squeezes margins. In one deal, U.S. telecom giant AT&T will acquire nearly 10 percent of Mexico’s subscribers with its $2.5 billion takeover of cell phone service provider Lusa-cell.

Much needs to be done to ensure that the reforms lead to the change everyone wants but that requires enlightened political leadership to attain. These reforms also show a maturity among politicians to work together, one that those north of the border would do well to emulate. Mexico’s problems are far from solved, but the outlook is good. The reforms will bear fruit. The trick is to keep away from the bottle and on the job at hand.

  

Sources/citations

https://www.investopedia.com/terms/t/tequilaeffect.asp

https://en.wikipedia.org/wiki/Mexican_peso_crisis

- Krueger, A. and Tornell, A. (1999) “The role of bank restructuring in recovering from crises: Mexico 1995-98” working paper 7042

- Haber, S. (2005) “Mexico’s experiments with bank privatization and liberalization, 1991-2003,” Journal of Banking and Finance 29: 2325–2353.

-Musacchio, A. (2012) “Mexico’s Financial Crisis of 1994-1995.” Harvard Business School Working Paper, No. 12-101, May 2012

- Nordgaard, T. (2013) “Hot Money and the Tequila Crisis, Comparing Capital Acount Regulatory Regimes: Mexico & Chili”

- Whitt, J.A. (1996) “The Mexican Peso Crisis” Federal Reserve Bank of Atlanta

1 A budget deficit is the difference between government expenditure and the amount raised by taxation.

2 Musacchio, Aldo. “Mexico’s Financial Crisis of 1994-1995.” Harvard Business School Working Paper, No. 12–101, May 2012. Stock market returns were as follows: +71.1% (1989), +34.6% (1990), +118.3% (1991), +21.2% (1992) and +48.4% (1993).

3 A crawling peg is a currency arrangement which allows for gradual movements up or down of the currency within broader limits.

4 Taking account of inflation.

5 A current account deficit is when the value of the goods and services exported by a country is less than the value of goods and service imported.

6 The Mexican Peso Crisis: Implications for International Finance.

Source: https://www.federalreserve.gov/pubs/bulletin/1996/396lead.pdf 

7 The Federal Reserve moved into tightening mode with increases in February, March, April, May, August and November.

8 Musacchio, Aldo.

9 Capital flight is when money leaves a country on concerns about political or economic risk.

10 Risk aversion describes the propensity for investors to move into less risky assets, such as cash and bonds.

11 Joseph A. Whitt, Jr., The Mexican Peso Crisis, 2.

12 Musacchio, Aldo.

13 The Mexican Peso Crisis.

14 A sovereign default is where a country cannot meet its interest payments on its debts.

15 GDP stands for Gross Domestic Product which is a measure of the productive capacity of an economy.

16 Economist, Tequila slammer, 29 December 2004.

17 A bank default is a loan where the borrower is unable to make repayment to the bank.

18 ‘Bottom-up’ investors focus on the company level, rather than broader sectoral or country analysis.

19 Leveraged financial structures involve high levels of debt relative to capital and opacity refers to a lack of transparency.