What Led to the Tequila Crisis?

As I mentioned in previous blog posts there were a number of both external and domestic factors that led to the Latin American Debt Crisis of the 70s. These decades of economic mismanagement eventually reached rock bottom for Mexico in 1994, in the form of the Tequila Crisis. Despite what the name suggests this crisis has less to do with the popular drink and more to do with the sudden devaluation of the Peso. Mexico's currency crisis of 1994 has been commonly dubbed the Tequila Crisis.

Mexico underwent serious Economic Reform in the 80s and early 90s. The Mexican government opened up the economy to International competition, privatised most state-owned enterprises and generally regulated the private sector less. The government also pegged the peso to the U.S dollar to keep inflation expectations in check and reduce investor uncertainty about exchange rate fluctuations. They combined this with tight monetary and fiscal policies and an explicit agreement that was negotiated yearly to keep prices down, this agreement was called the Pacto.

The adoption of a low-interest rate regime and the magnitude of the reform attracted a huge influx of foreign speculative capital, mainly from U.S banks and investors. Investors were convinced that Mexico was THE country to invest in. The speculative rush was driven by its own momentum. As more investors jumped on the bandwagon the price of Mexican stocks climbed higher and higher making it even easier for Mexican companies and the Mexican government to borrow what seems to have been an endless stream of U.S dollars.

The financial press added fuel to the fire by labeling the country's debt-fuelled growth as "The Mexican Miracle". The consequences of this now seem quite predictable, with cheap capital flowing freely, the country's banks eased their lending standards dramatically. As history proves time and time again, if something seems too good to be true.... it usually is.

As with all easy-money fuelled booms the good times came to an end. By 1994 The Mexican Miracle bubble had well and truly burst due to a mixture of political and financial forces. On the first of January 1994, a group of rebels called the Zapatistas launched a revolution in the province of Chiapas and months later in March of 1994 a Mexican presidential candidate was assassinated. These tumultuous events caused concern among investors for the country's political stability.

Fears grew among the public that the government would devalue the Mexican Peso. This devaluation did not happen until Ernesto Zedillo Ponce de Leon took office in December of 1994. At this stage, expectations had grown so much that the public devalued the currency even further, through their own actions. The era that was originally crowned the Mexican Miracle, ended up being a catastrophe for the country. The tequila crisis of 1994 shocked analysts, politicians and economists. Most people could not understand how a country praised as an example of economic strength could collapse so quickly.