At the start of 1994, Mexico was a star of emerging markets. The North American Free Trade Agreement (NAFTA) had just come into force, foreign money was pouring in and Mexico had joined the club of rich nations, the OECD. By the end of the year, its currency was collapsing. In Part 11 of Great Financial Crises, we look at the peso crisis, often called the "Tequila Crisis."
The setup
After the debt crisis of the 1980s (Part 7), Mexico carried out major reforms: privatising state companies, opening trade and controlling inflation. To build confidence, the peso was managed within a band against the US dollar. Foreign investors bought Mexican stocks and short-term government bonds, attracted by higher interest rates.
But Mexico was running a large current account deficit, financed by short-term foreign money that could leave quickly.
A year of shocks
1994 brought a series of political blows:
- 1 January: NAFTA took effect, and the Zapatista uprising began in the southern state of Chiapas.
- March: presidential candidate Luis Donaldo Colosio was assassinated.
- Later in the year, another senior politician was murdered and US interest rates were rising.
Investors grew nervous and began moving money out.
Tesobonos: the hidden risk
To keep foreign investors, the government increasingly issued tesobonos, short-term bonds payable in pesos but linked to the US dollar. This meant the government carried the currency risk. If the peso fell, the cost of repaying tesobonos in pesos would rise sharply.
At the same time, the central bank spent its dollar reserves defending the peso. By December 1994, reserves were running out.
The devaluation
On 20 December 1994, the new government devalued the peso by about 13% to 15%. Rather than calm markets, the move triggered capital flight. Two days later, the peso was allowed to float freely, and it fell further.
The peso lost about half its value, falling from about 3.4 to around 7.2 per US dollar. Investors feared Mexico could not repay its tesobonos, which were coming due in large amounts in early 1995.
The rescue
In January 1995, after the US Congress declined to pass a loan guarantee bill, President Bill Clinton's administration used the Treasury's Exchange Stabilization Fund. A package of about $50 billion was assembled:
- United States: about $20 billion.
- International Monetary Fund: about $17.8 billion.
- Bank for International Settlements: about $10 billion.
- Smaller contributions from Canada and Latin American countries.
Mexico repaid the US loans ahead of schedule, and the US reportedly earned a profit of about $600 million on them.
The human cost
The economic pain in Mexico was severe:
- GDP fell about 6.2% in 1995.
- Inflation reached about 52% in 1995.
- Unemployment rose from 3.9% in 1994 to 7.4% in 1995.
- Extreme poverty rose sharply, from about 21% in 1994 to 37% in 1996.
- Many borrowers could not repay loans with soaring interest rates, and banks needed a costly government bailout.
The tequila effect
The crisis spread to other emerging markets, particularly in Latin America, including Argentina and Brazil, as investors pulled money from countries they saw as similar. This contagion became known as the "tequila effect."
Why it matters
The peso crisis was one of the first crises of the modern era of global capital flows. It showed how quickly foreign money can leave, how currency pegs can fail and how hidden currency risks, like dollar-linked debt, can turn a devaluation into a crisis. It also set a precedent for large international rescue packages, which became a model, and a controversy, in the Asian crisis three years later.
Lessons for investors today
- Hot money can leave quickly. Countries relying on short-term foreign investment are vulnerable.
- Currency pegs can break. When reserves run low, a peg can collapse suddenly.
- Look for hidden currency risk in debt linked to foreign currencies.
- Contagion is real. A crisis in one emerging market can hit others, even if their fundamentals differ.
In Part 12, we look at the Asian financial crisis of 1997, which began in Thailand and spread across a region.
Sources
- Wikipedia – Mexican peso crisis
- US GAO – Mexico's financial crisis: origins, awareness, assistance and initial efforts to recover
Great Financial Crises: the full series
- Part 1: Tulip Mania (1637)
- Part 2: The Mississippi and South Sea Bubbles (1720)
- Part 3: The Panic of 1907
- Part 4: The Wall Street Crash and Great Depression
- Part 5: Weimar Hyperinflation (1923)
- Part 6: The 1970s Oil Shocks and Stagflation
- Part 7: The Latin American Debt Crisis (1982)
- Part 8: Black Monday (1987)
- Part 9: Japan's Bubble and Lost Decades
- Part 10: The Savings and Loan Crisis
- Part 11: The Mexican Peso Crisis (1994) (you are here)
- Part 12: The Asian Financial Crisis (1997)
- Part 13: Russia's Default and LTCM (1998)
- Part 14: The Dot-Com Bubble (2000)
- Part 15: Argentina's Collapse (2001)
- Part 16: The Global Financial Crisis (2008)
- Part 17: Iceland's Banking Collapse (2008)
- Part 18: The Eurozone Debt Crisis
- Part 19: The Covid Crash (2020)
- Part 20: The 2023 Banking Turmoil
This series is for education only and is not investment advice. Figures are taken from the sources listed and other commonly cited historical records, and may vary slightly between sources.
