The Mexican peso crisis of 1994 resulted from a sudden devaluation of the peso by 50% in December 1994, triggering a severe recession. Mexico had pursued economic reforms and joined NAFTA but still had a fixed exchange rate, large current account deficit, and government debt denominated in dollars rather than pesos. When political assassinations increased uncertainty, investors fled Mexico rapidly, depleting reserves and forcing further peso devaluations that caused a financial crisis and economic contraction. The U.S. intervened with a $50 billion bailout package that restored stability.

1. Mexico Economic
Crises-1994
The sudden devaluation of the peso by the Mexican
government in December 1994 resulted in a financial
crisis that cut the peso’s value in half and triggered a
severe recession.

2. Background
 In early 1990’s Mexican economy seemed healthy
 Recovery from the “lost decade” of 1980’s (1982 debt crisis and 1986 oil crisis)
The NAFTA started in early 1994 culminating a series of reforms:
Restructuring of foreign debt under the Brady Plan
Sharp reductions in budget deficit and inflation rate
Cuts in protectionist trade barriers
 Privatization of various government owned state companies
 Mexico became member of the OECD in May’94
(“The Club of the Wealthy”)

3.  The 1994 Economic Crisis in Mexico, widely
known as the Mexican peso crisis, became an effective crisis with the sudden
devaluation of the Mexican peso in December 1994.
 The impact of the Mexican economic crisis on the Southern Cone and Brazil was
labeled the Tequila Effect (Spanish: Efecto Tequila).
Mexico experienced recurring financial crises in 1976, 1982, 1986 and, 1994-1995
with devastating economic and social consequences.
 The most recent crisis that emerged in December
1994 was the worst with the peso losing 40% of its value.
Prior to the crisis, Mexico had a crawling peg exchange rate system. The peso-US
dollar exchange rate was kept within a narrow target
band, but the upper limit of the band was raised
slightly every day by a predetermined amount, allowing for a
gradual nominal depreciation of the peso.

4.  Exchange rate over-valuation and the current account deficit
were the two major problems in the Mexican economy in 1994.
 Given these problems, several additional factors helped to
trigger the crisis:
1) Elections, which are traditionally associated with devaluation,
2) The rise in U.S. interest rates,
3) Loss of investor confidence due to politically linked assassinations,
4) Loose monetary policy in response to the reduction in foreign
capital flows,
5) Expansion of quasi-fiscal expenditure via development bank credits, and
6) Shifting fiscal borrowing to short-term, dollar-denominated instruments.

5.  The Mexican economic crisis was the result of
policy mistakes that led to an investor panic. The
assassination of presidential candidate Donaldo
Colosio caused foreign investors to demand a
higher return on investments to compensate for increased perceived risk.
 The Mexican central bank fought the increase in
interest rates through an expansion of domestic
credit. This credit was converted to dollars and led
to a drain on Central Bank foreign exchange reserves.
 Meanwhile the exchange rate remained moderately over-
valued. Moreover, the Mexican government rolled over its short-term peso-
denominated debt into short-term dollar
denominated debt in an attempt to decrease the cost of government borrowing.

6.  The result of Mexican economic policy in 1994 was
to place the economy in a vulnerable position with
respect to its external debt: the government held a large amount of short-
term dollar-donominated debt, reserves had dwindled, and expectations of
a devaluation had developed.
 Once the first devaluation was announced on
December 20, investors panicked and ran from the
peso. The peso value of dollar-denominated
government debt rose sharply, as did interest rates for new government debt.
 The result was a government liquidity crisis. This crisis
in turn contaminated the private sector's credit-
worthiness and created the threat of a collapse of the banking system.

7. Fixed Exchange Rates
 Mexico maintained a crawling peg exchange rate system
 Government intervention kept the exchange rate vis-à-vis
the USD within a narrow target band, upper limit was raised slightly daily to up to ~2.3% p.a.
 In real terms the Peso was appreciating:
 Mexico inflation > US inflation + peso depreciation
 This encourage imports and discourage exports increasing
the current account deficit, which rose from 2.8% of GDP 1989 to +7% of GDP from 1992-94
 The Mexican government seemed unconcerned due to
increasing levels of international reserves (USD 30Bn in Feb’94)
The band floor was fixed at 3.051 Mexican pesos per US dollar. The band ceiling had been allowed
to increase 0.004 pesos a day and any increase of the peso – US dollar exchange rate beyond this
threshold would force the Mexican central bank to intervene and defend the parity.
 In December 1994, the Mexican government decided to devalue the peso by 15 percent, to
about four pesos per dollar and within a few days the peso plummeted, sinking the country into a
financial crisis which led to a 9.2% fall in real GNP per capita and a loss of 2 million jobs

8.  The band floor was fixed at 3.051 Mexican pesos
per US dollar. The band ceiling had been allowed to increase 0.004
pesos a day and any increase of the peso –
US dollar exchange rate beyond this
threshold would force the Mexican central bank to intervene and defend
the parity.
 In December 1994, the Mexican government
decided to devalue the peso by 15 percent, to
about four pesos per dollar and within a few days the peso
plummeted, sinking the country into a
financial crisis which led to a 9.2% fall in real GNP
per capita and a loss of 2 million jobs

10. Mexico’s Wild Year of 1994
 Mexico’s Central Bank blamed a series of political shock
in 1994 for the devaluation of Dec’94 that resulted in the financial crisis of 1995
 Jan’04 - Rebellion in the state of Chiapas by local Indians
 Mar’04 - Assassination of the official party’s presidential candidate (L.D. Colossio)
 Jun’04 – Kidnapping of prominent businessman (A. Harp)
 Sep’04 – Assassination of highest official of the ruling party
Sharp drop in Mexico’s international reserves
(USD 11Bn in 4 weeks in Mar’94)
Interest rate rose sharply and the peso depreciated
(8% in Mar’94 up to 15% in early Dec’94).

12.  As in prior election cycles, a pre-election disposition to
stimulate the economy, temporarily and unsustainably, led to post-
election economic instability.
 There were concerns about the level and quality of credit
extended by banks during the preceding low-interest rate
period, as well as the standards for extending credit. The
country's risk premium was also affected by an armed
rebellion in Chiapas, causing investors to be wary of investing
their money in an unstable region.
 The Mexican government's finances and cash availability
were further hampered by two decades of increasing
spending, debt loads, and low oil prices. Its ability to absorb
shocks was hampered by its commitments to finance past spending.
 In order to finance the deficit (current account
deficit 7% of GDP), Salinas issued the Tesobonos, a
type of debt instrument denominated in pesos but indexed to dollars.
 Mexico experienced lax banking or corrupt practices; moreover, some members of the Salinas
family collected enormous illicit payoffs.

13.  The EZLN, an insurgent rebellion, officially declared
war on the government on January 1; even though
the armed conflict ended two weeks later, the grievances and petitions remained a cause of
concern, especially amongst some investors
 The EZLN's violent uprising in Chiapas in 1994 along
with the assassination of Presidential candidate Luis Donaldo
Colosio made the nation's political future look less certain to investors, who then started
placing a larger risk premium on Mexican assets.
 Mexico had a fixed exchange rate system that
accepted pesos during the reaction of investors to
a higher perceived country risk premium and paid
out dollars. However, Mexico lacked sufficient foreign reserves to maintain the fixed exchange
rate and was running out of dollars at the end of 1994.
 The peso then had to be allowed to devalue despite the government's previous assurances to
the contrary, thereby scaring investors away and further raising its risk profile.

14.  When the government tried to roll over
some of its debt that was coming due,
investors were unwilling to buy the debt
and default became one of few options.
 A crisis of confidence damaged the banking system which in turn fed a
vicious cycle further affecting investor confidence.
 All of the above concerns, along with increasing
current account deficit fostered by consumer
binding and government spending, caused alarm
among those who bought the tesobonos.

15.  The investors sold the tesobonos rapidly, depleting
the already low central bank reserves. Given the
fact that it was an election year, whose outcome
might have changed as a result of a pre-election
day economic downturn, Banco de México
decided to buy Mexican Treasury Securities to
maintain the monetary base, thus keeping the
interest rates from rising. This caused an even
bigger decline in the dollar reserves.
 The peso crashed under a floating regime from
four pesos to the dollar to 7.2 to the dollar in the space of a week.
 The United States intervened rapidly, first by buying
pesos in the open market, and then by granting
assistance in the form of $50 billion in loan guarantees.
 The dollar stabilized at the rate of 6 pesos per dollar
By 1996, the economy was growing (peaked at 7%
growth in 1999). In 1997, Mexico repaid, ahead of schedule, all US Treasury loans.

16. Was Evolution Inevitable?
 Mexico’s private capital inflow totaled USD 95Bn from 1990-1994.
 Capital inflow did not financed long-term investment
spending (i.e. factories, equipment) that would have
helped built future export potential required to
reduced the current account deficit without slashing imports.
 Instead, capital inflow went into short-term financial
investments (i.e. bank deposits and government
bonds) that could flow out very fast in case of crisis.

18. Foreign Capitals Inflows

19. The Bailout
 The crisis was handled relatively quickly due
to the prompt response of the United States and the IMF in providing a
$50 billion line of credit.
 Mexico, in return, put up its oil revenues as collateral.
After a tough recession in 1995, Mexico began to recover strongly from the crisis.
The rescue package restored investor confidence and stopped the massive capital
outflows.
 Alan Greenspan believed that the immediate
problems arising if Mexico defaulted out-weighted the moral hazard problem.
 The US and Mexico negotiated terms of the loan
agreement (Mexico to limit money and credit and a
collateral of oil export revenues to be deposited at Fed)
The Peso continued to depreciate (up to $7.45) until
Mexico announced a stringent austerity package.

20. Conclusions
 Banking Crisis
 More frequent in periods of high international capital mobility
 More likely with fixed exchange rates
 The Mexican crisis may have had elements of a self-
fulfilling speculative attack: Calvo and Mendoza
(1995) argue that “a speculative attack can topple
an exchange rate peg even when economic
fundamentals are sound, if investors display herding
behavior and the country is financially vulnerable
with large amounts of ST debt”