The Tequila Crisis

The Tequila Crisis

Corinne Muller

Touro University

Global Finance

MBA 624

Dr. R. Wayne Ezelle

April 3, 2016

The Tequila Crisis

The Tequila Crisis

This paper discusses factors leading to the 1994 Mexican peso crisis popularly known as the “tequila crisis.”  These factors include weak banking regulation and oversight, a pegged exchange rate, excessive enthusiasm by foreign investors in short-term above average returns, political upheaval and violence, and rapid privatization and liberalization of trade rules.

Background

In the late 1980s, Mexico implemented economic reforms including deregulation.  President Miguel de la Madrid liberalized trade policies to integrate Mexico with the developed world.  Madrid reduced import tariffs and implemented other reforms to facilitate the inflow of capital and foreign investment.  He instituted a policy of privatization, passed legislation to attract foreign investment, restructured external debt, and granted independence to the Central Bank with the goal of stabilizing the purchasing power of the Mexican currency (The World Bank, 2001, p. 1).

For the better part of the the 20th century, Mexico followed a strategy of import substitution industrialization (ISI) whereby it established policies and regulations to protect Mexican industries from American and international competition.  This included levying high import tariffs, imposing other non-tariff barriers on foreign goods, and providing subsidies to Mexican industries.  This policy disincentivized Mexican producers to export goods because they held a domestic market monopoly (Musacchio, 2012, pp. 2-3).

Between 1979 to 1981, the United States Federal Reserve Board (“the Fed”) raised interest rates to control inflation.  This, and a decline in commodity prices, negatively affected the Mexican economy (Cardoso and Helwege, 1992 as cited by Musacchio, 2012, pp. 2-3).  Mexican exports fell, the cost of servicing debts denominated in foreign currencies rose, and pressures grew on the exchange rate.  In 1982, Mexico suspended its foreign debt repayments.  In response, investors around the world panicked, triggering a further rise in interest rates.  This forced other Latin American countries to suspend payments on their debt.  The International Monetary Fund (IMF) and the World Bank intervened and agreed to provide financial assistance conditioned on implementing economic reforms to achieve macroeconomic stability (Musacchio, pp. 2-3).  These reform measures included fiscal austerity with a strict monetary policy, the privatization of state-owned entities, reductions of trade barriers, the liberalization of the economy to international trade and capital, and the reduction of economic government intervention (Rabobank Economic Research, 2013).