Mexico: The Tequila Crisis 1994-1995

What Caused Mexico’s peso crisis of December 1994?

Mexico, the Latin American country that survived the huge debt crisis in the 1980’s found itself amidst one of the most viral economic crises that it had ever encountered in its history. The crisis took place under President Zedillo; however, the causes of the crisis are usually linked to Carlos Salinas de Gortari and his outgoing administration. Gortari’s government currency policy put an unbelievable strain on the nation’s finances.
In the early 1990’s, Mexico seemed to have established itself as a reformer and was establishing economic development. Domestic deregulation and privatization combined with liberalization of trade and investment led to rapid growth and massive inflow of direct and foreign investments. By May 1994 Mexico falsely believed that there was prosperity in the nation and that it in fact could be a first world nation. The Banks were just lending credit without conducting proper checks or having any accountability and it was widely known that the currency was overvalued and there was economic mismanagement taking place. The situation was not helped and led to a collapse in confidence by several political shocks that took place like the uprising in the South and the assassination of the leading presidential candidate (Gil-Diaz, the CATO journal vol.17 no 3).
The government’s corruption caused the increased account deficit fostered by consumer binding and government spending alarmed the investors who started selling their investments depleting the already low central reserves bank. In order to maintain the fixed exchange rate, the economically right thing to do, would have been to sharply increase interest rates by allowing the monetary base to shrink, as dollars were being withdrawn from the reserves. Instead, Banco de Mexico decided to buy Mexican treasury in order to keep the monetary base and thus keep the interest rate from rising. This action caused an even more decline in the dollar reserves. The decisions that were being made aggravated the already delicate situation and crisis was inevitable so the only thing the government could do was to devalue the currency in order to make some sorts of adjustments. The devaluation caused even more of a crisis as it crashed the peso from four pesos to the dollar to 7.2 to the dollar in the space of a week (Boroumand, 2010)

Have Capital inflows helped or hindered Mexico’s development strategy?

Macroeconomic stabilization was implemented through the introduction of the “Pacto”. The Pacto was an agreement that was between the representatives and the government in support of the overall macroeconomic strategy (Boroumand, 2010). With the Launch of the Pacto, the nominal exchange rate was used as an anchor as it would contribute to the elimination of inertial inflation and at the same time guarantee that the fiscal policy would maintain the necessary discipline. The Pacto was successful in bringing inflation down but as experience shows the use of nominal exchange rate-based stabilization results in recurring real appreciation of the local currency because it always takes time for the differential between the domestic and foreign inflation to decrease and Mexico was not an exception. The exchange rates real appreciation was exacerbated by the large amount of capital inflows experienced by Mexico in the early 1990’s. The capital inflows were the combined result of a deliberate policy of attracting private capital and the fall of the interest rates in the United States. The privatization of the banks that was announced in May 1990 and the intention to negotiate the free trades agreement with the US attracted capital inflow more openly. Of course these capital inflows were received with open arms because Mexico was still emerging from its traumatic experience with the debt crisis in the 80’s (Lustig, 1995).
Mexico had capital inflows flooding its banks and a surge of external investment had disturbed Mexico’s equilibrium. An inflow of funds meant that there was a sudden demand for assets with no comparable charge in supply. This forced the prices up in the country and drove the country’s currency as well. The upward pressure on prices drove up domestic inflation, and the pressure on the currency priced exports out of the global market. The surge of capital inflows into Mexico drove up the peso’s value beyond rationale levels so granted some form of devaluation was in order. As soon as devaluation was announced in December 1994 capital fled the country and the peso plummeted downwards and therefore causing the crisis. After the debt crisis in the 1980’s going through this crisis caused by the capital inflow definitely hindered the development that Mexico was strategizing to achieve (“The Contract with Mexico”, March, 1995).

References:

“The Contract with Mexico”. March 1995. Retrieved on 23 March 2010 from http://www.leftbusinessobserver.com/Mexico.html

Gil-Diaz, Francisco. “The origin of Mexico’s 1994 financial crisis”. The CATO Journal volume 17, no 3. Retrieved on 23 March 2010 from http://www.cato.org/pubs/journal/cj17n3-14.html

Lustig, Nora. “The Mexico Peso Crisis: the foreseeable and surprise”. June 1995. retrieved on 24 March, 2010 from http://www.brookings.edu/~/media/Files/rc/papers/1995/06internationalfinance_lustig/bdp114.pdf