The Mexican peso crisis, also known as the tequila crisis, is a slang term that is used for financial fallout resulting from the Mexican economy. It was one of the first major currency crises in the South American continent. The value of the Mexican peso almost collapsed as a result of this crisis. The number of foreign reserves in the country rapidly decreased to extremely low levels and in the end, the Mexican government had no other option left so they required a bailout to save the country from this crisis. Foreign investors who 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 look disastrous considering that bonds are fixed-income investments and losing money on bonds is considered to be a very rare possibility. So, what led the nation to this nightmarish disaster? Let’s delve into it. 

Currency Mismatch

The Mexican government witnessed a significant currency mismatch on its balance sheet. This meant that even though the Mexican government earned all their income in peso, they had taken a major section of their debt in US dollars. Mexico had a fixed exchange rate system, meaning that the country had fixed the value of its currency with respect to the US Dollar. This meant that the Mexican Central Bank would carry Forex 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 off their debt.

Maturity Mismatch

Along with the currency mismatch, the Mexican government also had a serious maturity mismatch on its debt. This indicated that a huge amount of debt was due and could not be paid because the government did not have sufficient reserves. Hence, in 1994, the government owed $35 billion including interest and principal payments, despite only having $6 billion in reserves which frightened the Mexican officials. Further, the Mexican government had already taken so much debt that it could hardly finance any more deficits by borrowing further money.

Current Account Deficit 

Mexico also had a huge current account deficit which meant that the level of importing of goods and services was greater than the exports. This deficit was largely funded by portfolio investments in the Mexican stock market. In the short run, it seemed to be safe. However, portfolio investment can leave countries within a matter of minutes. So, it was not at all a safe option to finance something as crucial as current account deficits. The Mexican government paid the price of this blunder later as it saw a huge exit of capital and had no resources to finance its deficits.

Political instability

The political condition in Mexico was not at all good as there were a lot of high-profile kidnappings going on at that time which made the investors feel very scared. Along with that the assassination of a Presidential candidate sparked fears amongst the investors. This made investors think that the law and order situation within the country had broken down. The media started making theories about the intensity of the situation and investors in the foreign exchange market started exiting the peso market as quickly as they could.

Increase in the US interest rates

During the late 1990s, the US had raised its interest rates. As the US was considered the most powerful economy in the world, so the investors who had kept their money in other parts of the world including Mexico thought it would be a better and safe option if they will move their money to the US as they were getting a better return there and they did not have to experience the risks that the Mexican economy brought along. Therefore, they took their money from Mexico and put it in the US and this further triggered the crisis.

Tabular representation of the crisis

Table 1: Overview of economic indicators

Source: IMF

Figure 1: Exchange rate

Source: Banco de Mexico

Impact of the crisis

The Mexican financial crisis of 1994 was one of the most serious setbacks the country faced in its history. With the devaluation of the Mexican peso, the country witnessed a severe recession. Till 1995 the country’s GDP declined by 6.2%. The economic hardship caused by the catastrophe was tremendous as the income levels and imports dropped, economic growth stagnated, unemployment rose to high levels, inflation reduced the buying power of the middle classes, poverty increased substantially and even the social fabric of the society was stretched thin. In addition to this, the investment that might have been used to solve social issues and poverty was instead being used to pay back the debt.

Response to the financial crisis

With the assistance of the United States government, Mexico was rescued from this situation and the circumstances began to recover in 1996. This is because Mexico imported American goods in a large proportion. Mexico also shared a long borderline with the United States, and political disturbances there could sooner or later enter America. Therefore, the American government by some means managed a $51 billion bailout so that the severity of the crisis in Mexico reduces. In return, Mexico had to keep its oil reserves as collateral. Moreover, Mexico had to face several restrictions which were imposed by investors, such as following strict monetary and credit growth policies till the whole of their debt was paid off.

Conclusion

The Mexican Tequila Crisis was triggered by a combination of various factors which include poorly carried out reforms, a fixed exchange rate system, current account deficits, an increase in interest rates in the US, and social unrest, which finally led to both a currency and banking crisis. The intensity of the crisis was reduced and further destruction was prevented with the help of the US and the IMF. If they did not intervene then the situation could have gotten worse as the banking sector, which was already in a bad shape, would have collapsed. The Mexican debt crisis is therefore a perfect case study of what can go wrong when countries try to keep false high-level Forex rates with the help of open market operations of their Central Banks.

 

– By Divyansh Kaul

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