What Was the Mexican Peso Crisis? Causes, Recovery, and History

What Is The Tequila Effect?

The Tequilla Effect (also known as "Tequilla Shock" or the "Tequilla Crisis") is a slang term for financial or economic fallout resulting from the Mexican economy.

The Mexican peso (MXN) has been the official currency of Mexico since the country gained its independence in 1821. The 1994 Mexican currency crisis was a sudden devaluation of the Mexican peso, which caused other currencies in Latin America (such as in the Southern Cone and Brazil) to decline as well. The effect of the crisis was informally known as the "Tequilla Effect" or the "Tequilla 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).

Key Takeaways

  • The Tequila Crisis began on Dec. 20, 1994 when the Mexican peso was devalued, causing a global currency crisis and resulting in a $50 billion IMF bailout to Mexico's economy.
  • Both domestic and international economic factors, along with political forces helped precipitate the crisis.
  • The central bank began converting short-term debt, denominated in pesos, into dollar-denominated bonds. The conversion resulted in a decrease in foreign reserves and an increase in debt.
  • A self-fulfilling crisis resulted when investors feared a default on debt by the government.

Understanding the Tequila Crisis: The 1994 Mexican Peso Devaluation

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.