The Mexican Currency Crisis (Tequila Crisis) of 1994

The Mexican peso crisis, which is also known as the tequila crisis was one of the first major currency crisis in the South American continent. The Mexican peso almost collapsed as a result of this crisis. The government was close to default on its national debt. The level of foreign reserves was dwindling to dangerously low levels and in the end the Mexican government required a bailout to stay afloat financially. Also, foreign investors that had invested in Mexican bonds ended up losing 15% of the value of their investments in a single day and over 40% of the value in the long term. These rates are catastrophic considering that bonds are fixed income investments and losing money on bonds is considered to be a very distant possibility.

Causes of the Mexican Crisis of 1994

• Currency Mismatch: The Mexican government faced a major currency mismatch on their balance sheet. This meant that even though the Mexican government earned all their revenues in peso, they had issued a major portion of their debt which could be converted into United States dollars. Thus the Mexican government owed money in US dollars whereas its receipts were in pesos.

  Ideally, a government can swap the pesos for dollars on the market and pay off their debt. However, the Mexican government was maintaining a currency rate peg with the United States. This meant that the Mexican Central Bank would conduct foreign market operations to keep the value of their debt stable as compared to the United States. Hence, they needed dollar reserves to conduct these operations and therefore did not have the dollars to pay up on their loans.

• Overvalued Peso: The Mexican government had maintained a currency peg with the United States. As a result, the value of the peso would float in tandem with the United States dollar. Hence, if the value of the dollar went down by 5%, the Mexican government would conduct Forex operations to ensure that the value of the peso also went down by exactly 5%.

  A currency peg can be dangerous if there is runaway inflation in any country. This was the case with Mexico where the government was creating credit in huge quantities driving inflation through the roof. If the peso were a freely floating currency, it would have undergone a serious devaluation. However, since the peso was pegged, its value remained stable to the dollar. Hence it was extremely overvalued which could have been observed by the rising imports and the dwindling exports.

• Current Account Deficit: The Mexican government was also facing a major current account deficit because of the overvalued peso. This deficit was largely being financed by portfolio investments in the Mexican stock market. In the short run it appeared to be harmless. However, portfolio investment can leave countries within a matter of minutes. Therefore, it is an unstable foundation to finance something as important as current account deficits. The Mexican government paid the price of this mistake later as it witnessed a massive flight of capital and had no avenues to finance its deficits.

• Maturity Mismatch: Along with currency mismatch, the Mexican government also had a major maturity mismatch on its debt. This meant that a large amount of debt was to come due almost immediately in 1994. This was dangerous given the fact that there were no reserves to pay off the debt. Hence, in 1994, the government owed $35 billion in interest and principal payments whereas it only had $6 billion in reserves bringing shivers up the spine of Mexican officials. Also, the Mexican government was so far up in debt that it could hardly finance any more deficits by borrowing more money.

• Political situation: The political situation in Mexico also began to scare investors. There were a lot of high profile kidnappings during that time which suggested to investors that law and order situation within the country had broken down. Also, there was the assassination of a Presidential candidate which sparked further fears amongst investors. Also, the Mexican president started seeking counsel of his foreign minister, eminent economists and labor unions in a very public manner. The media started speculating about the gravity of the situation and investors in the Forex market started exiting the peso as fast as they could.

• US Interest Rate Increase: The last nail in the coffin for the Mexican government was the fact that interest rates in the United States rose at the same time. Investors were getting a better return without having to face the risks that the Mexican economy brought along. Hence, investors started dumping dollar denominated Mexican debt and buying United States treasuries. Mexican debt had no buyers and given the rapid devaluation of the peso, Mexico was headed towards troubled times.

Consequences of the Mexican Crisis of 1994

• Peg Abandoned: The Mexican government was forced to abandon the peg with the United States dollar since it did not have the reserves to keep trading on the Forex market and manage the exchange rate. This led to the rapid devaluation of the peso and caused considerable economic, political and social turmoil in Mexico.

• Bailout: The United States government had to come to the rescue of the Mexican government. This is because Mexico was a major importer of American goods. Also, Mexico shared a long border with the United States and political turmoil there would ultimately find its way to America.

  Therefore, the American government somehow managed a $51 billion bailout for easing the situation in Mexico. In return, Mexico had to pledge their oil reserves as collateral. Also, Mexico was bound by investors to follow stringent monetary and credit expansion policies till their debt was paid off.

The Mexican debt crisis is therefore a case in point of what can go wrong when countries try to maintain artificially high Forex rates with the help of open market operations of their Central Banks.