Tequila Effect Essay

The Tequila Effect, also referred to as the 1994 Mexican Peso Crisis, is the informal name given to the effects of the 1994 currency crisis that originated in Mexico. It occurred as a result of political turmoil and social unrest in Mexico in 1994 and delays in making the necessary adjustments to Mexico’s monetary policy during that time period. The crisis also affected other emerging economies that were similar to Mexico, in particular South American economies.

Since November 1991, Mexico operated a pegged exchange rate system in which the peso, the currency of Mexico, was initially linked to the U.S. dollar at a fixed exchange rate, and was allowed to trade within a set range. In 1994, the peso was devalued by 10 percent, but that devaluation was seen as insufficient, leaving the peso to remain overvalued. To keep the peso within its band, Mexico’s central bank had to simultaneously manage the peso-dollar exchange rate and the money supply. Given the economic and political conditions at that time, the simultaneous management of the foreign exchange rate and the money supply proved to be a difficult balancing act.

Following the 1994 assassinations of Luis Donaldo Colosio and José Francisco Ruiz Massieu, two key political figures of the Party of Institutional Revolution (PRI), which dominated Mexican politics for decades, investors sensed choppy waters. The same year also saw a time of transition at the helm of Mexico, and the outgoing president was reluctant to devalue the peso during his term of office. It was feared that allowing the peso to devalue would cause generalized discontent among the population, as it did in the election years of 1976 and 1982. The issue of allowing interest rates to rise was controversial as well. First, it would further strengthen an already-overvalued peso. Second, it would raise the cost of capital to the private sector. Third, it could lead to a bank run, as nonperforming loans weaken banks’ assets and rising costs of deposits heap more pressure on banks’ liabilities. To ease the pressure on interest rates, the Central Bank of Mexico expanded credit by loaning more funds to commercial banks and by purchasing government securities held by corporations and the public.

The government’s resistance to further increase interest rates and to devalue the peso meant that reserves had to be run down. With an overvalued peso, it was cheaper for Mexicans to import foreign-made goods and more expensive for foreigners to buy goods made in Mexico. The overvalued peso led to increased imports and decreased exports, and a widening current account deficit.

A current account deficit can be financed by private capital in-flows and/or changes in foreign exchange reserves. The political turmoil and social unrest of 1994 caused private capital in-flows to dry out. Hence, foreign exchange reserves were used mainly to finance the deficit, causing Mexico to eventually run out of reserves. As a result, the Central Bank of Mexico soon ran out of reserves to guarantee deposits in the event of a bank run. The fact that a sizable chunk of total deposits were in dollar-denominations made matters even worse for foreign investors. In December 1994, an auction of government securities (to buy time for the Mexican government, hoping the shock would be transitory) failed, and that kick-started a wave of panic among investors.

Financial Panic

Given Mexico’s political chaos, weak capital market, and low protection of investor rights, rumors of an imminent devaluation of the peso led to a capital flight out of Mexico, and the peso overflowed currency markets. The combination of political instability, an overvalued currency that may be subject to speculative attacks, huge current account deficits, and dwindling foreign exchange reserves (overtaking any benefit of Mexico joining the North American Free Trade Agreement [NAFTA] in 1994) contributed to its economic collapse. The Mexican government finally perceived the costs of defending the exchange rate to be too high and had to let the peso devalue. The devaluation led to extreme financial panic. Given that in 1982 the Mexican government froze dollar-denominated deposits and paid them back at an exchange rate well below market rate, investors feared that a repeat of that event could occur. Moreover, fearing a contagion effect, investors pulled out funds from other markets with characteristics similar to Mexico.

To contain the effects of the Mexican crisis and possibly to quell criticisms that Mexico’s membership in NAFTA was hasty, the U.S. government and the International Monetary Fund (IMF) responded with a $52 billion aid package. The size of this international line of credit helped in appeasing investors’ panic and bolstering confidence back in the Mexican economy.

 

Bibliography:

  1. Mark Aguiar, “Investment, Devaluation, and Foreign Currency Exposure: The Case of Mexico,” Journal of Development Economics (v.78/1, 2005);
  2. Ann Brocklehurst, “For Latin America, Peso Crisis Made 1995 a Good Year to Forget: A Region That Can Only Go Up,” www.iht.com (cited March 2009);
  3. Moritz Cruz, Edmund Amann, and Bernard Walters, “Expectations, the Business Cycle and the Mexican Peso Crisis,” Cambridge Journal of Economics (v.30/5, 2006);
  4. Antonio Jorge et al, eds., Capital Markets, Growth, and Economic Policy in Latin America (Greenwood, 2000);
  5. “Tequila Effect,” www.investopedia.com (cited March 2009);
  6. Sidney Weintraub, Financial Decision-Making in Mexico: To Bet a Nation (University of Pittsburgh Press, 2000).

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