The "Tequila Effect" was the informal name given to the impact of the 1994 Mexican economic crisis on the South American economy. The Tequila Effect occurred due to a sudden devaluation of the Mexican peso, which caused other currencies in the region (the Southern Cone and Brazil) to decline as well.

It is also referred to as the "Mexican Shock."

The falling peso was eventually propped up by a $50-billion bailout package coordinated by then U.S. President Bill Clinton and administered by the International Monetary Fund (IMF).

Breaking Down the Tequila Effect

On December 20, 1994, the Mexican central bank devalued the peso between 13 and 15 percent. To limit the excessive flight of capital, the bank also raised interest rates. Short-term interest rates rose to 32 percent, and the resulting higher costs of borrowing were a danger to economic stability.

The Mexican government allowed the peso to float freely again two days later, but rather than stabilize, the peso took another sharp hit, depreciating nearly into half of its value in the months that would follow.

Immediately after the Mexican peso was devalued in the early days of the Presidency of Ernesto Zedillo, South American countries also suffered rapid currency depreciation and a loss of reserves. Foreign capital not only fled Mexico but the crisis led to financial contagion in emerging markets as well.

It was a known fact that the peso was overvalued, but the extent of Mexico's economic vulnerability was not well known. Since governments and businesses in the area had high levels of U.S. dollar-denominated debt, the devaluation meant that it would be increasingly difficult to pay back the debts.

The Mexican Debt Bailout

In response to the crisis, the U.S. Congress passed the Mexican Debt Disclosure Act of 1995, which was enacted by President Clinton on April 10, 1995. The law provided billions in financial assistance for swap facilities and securities guarantees using American taxpayer dollars, and additional assistance provided by the IMF.

The Mexican government—as a condition of the sizable bailout—was required to implement certain fiscal and monetary policies controls. They were also careful to maintain their existing commitments to policies of the North American Free Trade Agreement (NAFTA). Mexico suffered through a severe recession and bouts of hyperinflation in the years following the crisis, as the country maintained excessive levels of poverty for the remainder of the nineties.