The Mexican Peso Crisis (1994–1995): The 'Tequila Effect'

Mexico in 1994: A Country That Seemed to Be Transforming

At the beginning of 1994, Mexico appeared to be a success story: it had just signed NAFTA (a free trade agreement with the USA and Canada), was privatizing state-owned enterprises, reducing the deficit, and receiving floods of foreign investment.

President Salinas de Gortari was celebrated as a modern reformer. Mexico had been admitted to the OECD, the 'club of rich countries.' The peso was pegged to the dollar in a fixed band.

The 1994 Crises That No One Saw Coming

1994, however, brought a series of political shocks:

• January 1, 1994: Zapatista uprising in Chiapas (the day NAFTA went into effect)
• March 23, 1994: Assassination of PRI presidential candidate Luis Donaldo Colosio
• September 28, 1994: Assassination of the ruling party secretary
• Rise in US interest rates: The Fed raised rates six times in 1994, reducing the attractiveness of Mexican investments

These shocks led to an accelerated capital flight throughout the year. Mexican foreign exchange reserves, which were at $29 billion in February, fell to $6 billion by December.

The Christmas 'Gaffe': The Mishandled Devaluation

On December 20, the new Zedillo government (which had taken office just two weeks earlier) announced a 15% devaluation of the peso. The decision was poorly presented, the communication was disastrous, and the markets immediately understood that reserves were almost exhausted.

Panic was immediate. Within 24 hours, the peso lost not the announced 15%, but 40%. Foreign investors fled tesobonos (Mexican government bonds denominated in dollars) in mass, and Mexico found itself unable to repay them.

The Tequila Effect: Latin American Contagion

Like a financial virus, the Mexican crisis spread rapidly:

• Argentina: The stock market collapsed by 28%, capital flight occurred
• Brazil: Currency collapse, stock markets plummeting
• Venezuela: Banking crisis
• Peru and Bolivia: Significant capital flight

Investors could no longer distinguish between the different countries: 'they are all the same, all at risk.'

The Clinton Bailout: 50 Billion in 3 Weeks

Clinton understood that a Mexican default would have catastrophic consequences: millions of illegal immigrants heading to the USA, political destabilization on the borders, and a domino effect on the entire international financial system.

He built an unprecedented bailout package:

• $20 billion from the US Exchange Stabilization Fund
• $17.8 billion from the IMF
• $10 billion from the BIS (Bank for International Settlements)
• Total: $50 billion

Congress refused to approve the plan. Clinton implemented it unilaterally using the presidential fund.

The Exit from Crisis and the American Happy Ending

Mexico implemented severe austerity measures. Surprisingly, it recovered relatively quickly:

• The peso stabilized by 1995
• Growth resumed in 1996
• Mexico repaid the entire US loan early in 1997
• The USA profited: it collected $580 million in interest

Clinton commented: 'It was the best financial decision I made as president.'

Lessons for Investors

1. Fixed exchange rates are vulnerable: when reserves run out, devaluation becomes inevitable—and it is usually much worse than what is announced
2. Currency contagion is real: the Mexican crisis hit Argentina without any immediate fundamental problems in Argentina
3. Communication matters: a poorly announced devaluation becomes a currency crisis
4. Emerging markets require abundant reserves: the lesson from Mexico led emerging countries to accumulate massive reserves in subsequent years