Delving Deeper into the Tequila Crisis

My last blog post examined the so-called “Mexican Miracle” and discussed the factors that led to the Mexican Peso Crisis of 1994. Today I’m going to look at what options the Mexican government had in December of 1994 and consider some of the crucial errors officials made in the aftermath of the crisis.

The Mexican government had no easy option. They knew that the exchange rate peg needed to be abandoned however, they were also aware that keeping the peso pegged at a fixed rate had been a cornerstone of the Mexican reform programme. The fact that such a large portion of Mexico’s foreign debt was denominated in dollars made things even more difficult. A lack of foreign exchange reserves almost certainly meant that the government would have to default on these debts. On December 21st of 1994, the Mexican government lost 4.6 billion dollars in central bank reserves as investors moved money to other countries. With foreign reserves now less than 6 billion dollars in total Mexico was days away from having to default on their dollar-denominated bonds. The president-elect Ernesto Zedillo asked the minister of finance for his recommendation. He said the only option was to float the peso.

An emergency meeting of the Pacto was set up. This called for business leaders, labour leaders, and government officials to meet up to find a way to ensure inflation did not take off with the decision to float the peso. In the words of Andrés Oppenheimer, “that is when the new Zedillo government began to make a string of blunders that- mixed with a dose of bad luck- turned a critical situation into a financial debacle”.

I think that the biggest mistake the Mexican government made is that they discussed the possibility of floating the peso, which would clearly result in a devaluation. The Pacto meeting that was called took place after business hours, at 8 pm at night. This signaled to investors that the government was in trouble. The urgent meeting was not kept private in any way, reporters were gathered outside of the building waiting for officials to arrive. Before the Pacto meeting even began, business leaders were withdrawing their peso deposits and moving them abroad.

The fact that the government did little to hide how bad their situation was made investors eager to dump their pesos. Zedillo initially announced a 15% devaluation of the peso. The day after the Pacto meeting there was 4 billion dollars of capital flight from the country and the stock market value plummeted. The Mexican government's reputation in financial markets took a hit and hence lost its access to foreign credit markets.

As you can see from the graph above the free-floating peso lost almost 50% of its value against the dollar over the months following the initial devaluation, wiping out the savings of most of Mexico's middle class. The Peso crisis of 1994 is considered to be one of the first international financial crises caused by capital flight.