Mexico's Financial Crisis: The Tequila Crash

The Mexican crisis raised, throughout the world, a number of questions regarding the sustainability of the market oriented reform process in the world. The crisis and eventual demise of the Mexican exchange rate peg was, both sudden and dramatic. It not only marked a new style of crisis, it also became a contaminating virus that spread both in Latin America as well as in Asia. Understanding the way events unfolded in Mexico during the early 1990s continues to be fundamentally important to assessing the mechanics of the currency crises. However it is important to take into consideration that due to a combination of political interests and bad policymaking, Mexico ended up with a crisis that could have been avoided. Was the crisis driven by policymaker incompetence or by panic by foreign investors (the majority were American) and fragile capital markets? Political interests prevailed over economic logic in this matter.

In the context of important but still partial economic liberalization under President Carlos Salinas de Gortari in the late 1980’s and early 1990’s, Mexico began to experience fast economic growth and, with it, rising current account deficits, which grew from 2.5% of Mexican gross domestic product (GDP) in 1988-1989 to nearly 7% in 1992 and 1993. Foreign capital inflows had been helping to offset Mexico’s growing current account deficits in the early 1990’s, these inflows contracted as a result of increases in US interest rates. Political instability, including the outbreak of a rebellion in the underdeveloped and poor region of Chiapas and the assassination of the candidate Luis Donaldo Colosio of the ruling Institutional Revolutionary Party (PRI), was also a major source of capital outflow. Both Mexicans and foreigners began to withdraw capital from the country.

It appeared Mexico will be able to defend its fixed exchange rate through the increase of interest rates and the increase of borrowing from the US and Canada ( its newly partners in NAFTA). The reserves appeared to stabilize, the exchange rate began to reduce its volatility and the interest rates began to decline. Political uncertainties about the newly elected President Ernesto Zedillo, maintained the investors expectations very sensible, and with the re-eruption of the crisis in Chipas and the assassination of a former secretary Ruiz Massieu, the perception, in the country and abroad, that Mexico could not meet its public debt obligations led Mexicans and foreigners to sell pesos. International reserves dropped more than 10 billion dollars by December, and the government decided to abandon the peg and let the peso float. The peso lost more than 40% of its value. After spending approximately 75% of its foreign exchange reserves over a period of eight months in an attempt to maintain the peg, on December 22, 1994, the Mexican government ceased its efforts to keep the peso fixed against the dollar, and by late January 1995, when the United States intervened with a massive bailout package for Mexico.

This episode in the history of Mexico will not be forgotten. It is an episode were millions lost their jobs. It is an episodes that reminds us of the vulnerability of financial markets in emerging economies. It is an episodes that makes clear that capital is in constant movement, and sometimes it may favor you and sometimes it may not. It is an episode that reminded us that in order to include ourselves in this global era, legislation and institutions must be modernized. It is an episode that reminded us that many social and political problems in Mexico are still not resolved.