The Mexican Peso Collapse of 1994

Alejandro Lopez Rangel
The Mexican Peso Collapse of 1994

Introduction
After the end of the recession of Mexico in the 1980s, it was surprising that the Mexican
economy looked stable and gave a sense of full economic potential by 1993. During the 1980s,
Mexicos economy was mainly guided by the domestic market, protectionism, and strong
regulation. Irrespective of past struggles such as, the 1980s Lost Decade, 1982 Debt crisis,
and the 1986 collapse of oil prices; Mexico had an optimist view due to the NAFTA approval.
The approval of NAFTA took effect at the beginning of 1994, and this led to the belief that these
proposed low trade barriers would help attract domestic and foreign investors. NAFTA was the
continuation of a series of reforms, primarily GATT, which started in the mid-1980s as a part of
the De La Madrid administration (1982-1988).
The changes in the trading reforms between the U.S. and Mexico created excessive
enthusiasm about investing in Mexico as a foreigner. However, political and social violence in
Mexico, as well as changes in monetary policies in the United States caused Mexico to enter in
the worst crisis in Mexican history. This crisis led to the largest depreciation of the currency in
one year, known as the The Tequila Crisis. This essay explains the problems that led to the
Mexican crisis of 1994-1995, as well as its short- and long-term consequences.
Origins of the Crisis
Before 1986, Mexico was a closed economy, but its government decided to liberalize its
trading sector with United States. The General Agreement on Tariffs and Trade (GATT) was their
1
first attempt and it aimed to liberalize and regulate the international system. Although GATT was
created in 1947, Mexico did not join until four decades after its creation. When Mexico joined
GATT in 1986, its economy became more open, it developed the deregulation of industries, the
privatization of government-owned enterprises, and the reduction of trading tariffs. Mexicos
tariffs on decreased on imports by the end of 1980s; Furthermore, to encourage trade and price
stability, the Mexican peso was fixed with the U.S. dollar. The privatization of the banking
system, through market-oriented reforms, helped reduce government control. Two of the goals
of the program [Privatization] were to increase competition and efficiency in the financial system
and to improve bank capitalization (Hernndez-Murillo 5-6). By July 1992, the Mexican
government had sold its eighteen banks at a high price-to- book value ratio of 3.49. In relation
to this, the public debt from early 1980s was paid down by its government.
Free Trade Liberalization
The trading reforms led to an economic prosperity; Mexico not only began to attract
foreign investors, but also became popular with the new deregulation of major trade restrictions.
By early 1990s, the Mexican economy was following a path of success. Inflation shrunk,
investment was attractive, and money flowed into the country, and this caused the Mexican
central bank to have billions of dollars in reserve. Although Mexico significantly reduced trading
barriers with the passage of GATT, some barriers remained. The process of free trade and
liberalization continued and in 1994, the North American Free Trade Agreement (NAFTA)
surged to reduce trade restrictions between the United States, Canada, and Mexico. Months after
the implementation of NAFTA, Mexico plummeted and the peso devalued, inflation rates soared
high, and they consequently entered a severe recession. In the following analysis we are
observing the study of some of the main factors that influenced the Crisis of 1994, also known as
The Tequila Crisis.
The Peso Collapse
In the early 1990s the peso had a crawling peg exchange rate system, this meant that it
was fixed with the U.S. dollar. As shown in Graph 1 (Appendix B), the peso was fixed to the
U.S. dollar at a nominal exchange rate of 1 peso to $0.28. During that same time, Mexicos
inflation rate was higher than the inflation rate of the United States. This resulted in an increase
in prices of Mexican domestic products while maintaining a steady price on imports from the
United States, due to the pegged nominal exchange rate. As stated in Abel, Bernanke, and
Croushores Macroeconomics book, When the [peso] appreciates, it can buy more units of
foreign currency and thus becomes stronger. With the Mexican peso appreciating, U.S imports
became more affordable for Mexican consumers, increasing the current account trade deficit. The
balance of trade refers to the difference between a countrys imports and exports. If the total
value of goods and services imported are greater than the total value of goods and services
exported, then a country is said to have a trade deficit.
There were three main types of capital inflows into Mexico from 1990 through 1994
totaling $95 billion, as shown in Chart 2 (Appendix A). The first inflow is the direct investment
by foreigners, who were mainly big companies buying and building factories, retail stores, and
other property, plant, and equipment in Mexico. Through the ratification of NAFTA, direct
investment rose to total a quarter of the total capital inflow into Mexico during those years. This
type of investment was the smallest type of inflow and was usually long-term and lacked
liquidity, meaning it cannot be reversed quickly and at a low cost.
The second inflow is investment from foreigners that took the form of purchases in the
Mexican stock market. This was the second largest inflow of investment flowing into Mexico.
The third and largest form of investment was the purchases of bonds, mainly government bonds.
Over the first five years of the 1990s, foreign investors were putting money into Mexico due to
the high interest rate of return. Unlike direct investment, short-term government bonds could be
liquidated fairly quickly. Funds that easily flowed in and financed current account deficits could
also easily seek to flow out if conditions or perceptions changed (Truman M. 5). Mexico
became dependent on foreign investment and started to hold more risk due to investors
sentiment.
The Mexican current account deficit was increasing massively due to a rise in capital
inflows from foreign investors in early 1990s. This led to an increase in the supply of pesos in
foreign markets. As shown in Graph 2 (Appendix B), current account deficit puts downward
pressure on the pesos value, but offsetting effects also increased the demand for pesos from
foreign savers looking for higher rates of return in Mexico relative to the U.S. Chart 1
(Appendix A) shows that the capital account had a surplus due to the high rates of return earned
on Mexicos stock market. It is also visible that the current account deficit and capital account
surplus were inversely related in early 1990s, roughly balancing out. Graph 2 (Appendix B)
shows the balance of supply and demand for pesos in the foreign exchange markets in early
1994. Despite the great amount of supply resulting from the current account deficit, the demand
in public and private international investments flowing into the country, known as the capital
account, also remained strong, stabilizing the value of the peso in relation to the dollar.
U.S. Federal Reserve and Mexicos Uncertainty

United States played an important role on Mexicos economic uncertainty during the
90s. The U.S. government became more cautious after its recessionary period during 1991 and
the major fallout in their savings and loans, causing its government to apply expansionary
monetary policies. The expansionary monetary policy caused a reduction in its interest rates, this
helped boost U.S. banking system while saving the U.S. savings and loan industry (Kaplan, Jay).
After the recovery, inflationary indicators showed possible resurgent inflation; consequently,
the FED stopped monetary expansion, and shifted to a contractionary monetary policy, shown in
Graph 4 (Appendix B), selling bonds to reduce money supply and raise interest rates. The U.S.
Federal Reserve funds rate raised seven times over a period of one year. The increase in U.S.
interest rate caused attraction on U.S. bonds.
Political and Social Shocks
During 1994, Mexico suffered a political and social shock. The first shock occurred
during at the beginning of the year, when southern province of Chiapas rebelled. The cause of the
sudden rebellion was due to NAFTAs approval. The indigenous people of Chiapas were
threatened by liberalization treaties due to the possibility of replacements of goods provided by
local workers with imports. The second and most influential shock was the assassination of
presidential candidate Luis Donaldo Colosio. Miguel Salinas de Gortaris administration
appointed Luis Donaldo Colosio to represent the Party of Institutional Revolution (PRI), for the
next presidential election. This election was crucial for The Party of Institutional Revolution
(PRI), which had been dominating Mexicos government for the last sixty years. Even though
Luis Donaldo Colosio had optimistic polls and appeared to be Mexicos next president by the
end of 1994, he was still campaigning throughout the country. On March 23, 1994, Mexicos
ruling partys presidential candidate, was assassinated while campaigning in the northern town of
Tijuana (Springer, Gary L, and Jorge L. Molina 2-26). The 1994 events caused turmoil in
Mexicos economic stability, starting with the takeoff of foreign investors.
Increased risk in Mexican market due to social instability as well as the increase rate of
return in the U.S market, led investors to move their assets away from the Mexican market, in
favor of U.S. assets. As investors left Mexican markets by selling their assets, the demand for
peso started to decrease while the supply for these assets increased. These effects are shown in
Graph 3 (Appendix B), the decrease in demand for peso shifted the demand curve to the left,
while the supply curve shifted to the right due to the continued increase in the supply of pesos,
causing the peso to devaluate.
Short-Term Consequences
By the end of 1994 the peso devaluated to almost 8 pesos per dollar, as shown in Chart 3
(Appendix A); the largest devaluation in Mexican history. Due to the fact that Mexicos GDP
depended massively on international trade, the effects of the devaluation were strongly reflected
in a large reduction in the GDP, as shown in Chart 4 (Appendix A). The peso devaluation also
led to an increase in prices of imported goods. Many Mexican businesses depended in raw
material imported mostly from the U.S. Higher imported raw materials prices raised production
costs, and consequently increased the prices of final goods. As a result of a cheaper peso
compared to other currencies, Mexican exports became cheaper, therefore increasing; causing the
current account deficit to turn into a surplus by the end of 1995.
Long-Term Consequences
Right after the devaluation of the peso, Mexico negotiated with international financial
institutions and the United States, to receive a financial package to support the peso. Mexico had
no other option but to leave the crawling peg and let the exchange rate to float. With the
continuation of NAFTA, Mexico grew from 6-8% each year from 1996 to 1998. With the peso
devalued, Mexican exports became cheaper for the United States, therefore increasing. Mexico
continued implementing liberalization, privatization, deregulation policies from previous years
and managed to stabilize in the year after the devaluation of the peso.
Conclusion
While NAFTA was not the only factor that led to the Tequila Crisis, it had a big
influence in two main ways. Our first hypothesis states that the newly adopted reform increased
the desire of foreign investors to invest in the Mexican market, therefore increasing capital
inflows. It also reduced restrictions to invest, which made Mexican assets more liquid. The
second hypothesis we ended up with is that NAFTA created political and social instability in
Mexico, increasing the volatility of owning Mexican assets. We suggest that while trading
policies increased capital inflows to Mexico, they were also a response to the low interest rates in
the United States. As capital inflows to Mexico were increasing, the current account deficit was
also increasing at a fast pace. The peso was appreciating, meaning the prices for Mexican goods
and services were rising relative to the U.S goods and services. Thus, Mexican residents were
encouraged to increase imported goods and discouraged Mexican exports. Everything
plummeted when social and political instability in Mexico increased the volatility in the market.
In addition to that only that, the United States decided to increase the interest rate of return of
their assets, and this made foreign investors in the Mexican market to switch its assets to the U.S.
market. This caused a huge increase in capital outflows and decreased the demand for pesos, as
well as a huge increase in supply for the currency. There was no other option but to devalue the
peso and suffer the consequences of poor economic management by the Mexican government.
Despite the struggles at the beginning of the implementation of NAFTA, Mexico accomplished
to survive the Tequila Crisis thanks to the free trade reform.
Three main lessons rise from Mexicos peso devaluation. First, if countries are going to
run a current account deficit, they should be sure that capital inflows are well invested.
Depending too much in short-term liquid assets is risky since any shock can affect investors
perceptions, and make investors transfer their assets to other countries that pay higher rate of
return. Second, having a fixed exchange rate for a short-term might seem beneficial, since
lenders and borrowers know the value they are going to get when making choices, but having a
prolonged fixed exchange rate is dangerous and almost impossible when this changes, especially
when the cost of defending them is too great. The final lesson is focused in free trade
liberalization. When a close economy is opened through policies of free trade and liberalization,
investment and trade increases, enabling countries to grow and increase productivity globally.
Appendix A
Chart 1
Mexicos Current and Capital Accounts (Quarterly)
Source: IMF, International Financial Statistics
Chart 2
Foreign Investment Flows to Mexico
Source: Banco de Mexico
10
Chart 3
Exchange Rate, Pesos per U.S. Dollar (Quarterly)
Source: Banco de Mexico, Statistics
11
Chart 4
Real GDP Growth (Annual %)
Source: World Bank
12
Appendix B
Graph 1
The Initial Value of the Peso
S0
P0 ($0.28)
Value of pesos,
D0
Quantity of
Graph 2
Stable Exchange Rate Value
S0
S1
P0
Value of pesos,
D0
D1
Quantity of
Graph 3
13
Financial Capital Flees Mexico Collapsing the Value of the Peso

S0
S1
P1
P0
Value of pesos,
D1
D0
Quantity of
Graph 4
Contractionary Monetary Policy
14
Figure 1 Money Market
Figure 4 LM-IS Curve
LM1
LM0
FE
M1
M0
Real Interest
r0
r1
Interest
r0
MD
IS
Quantity of
Y1
Output, Y
Figure 3 Bond Market
Figure 4 Exchange Rate

S0
S1
S0
S1
Value of U.S.
P1 P0
Price of
E0
D0
Quantity of
D0
D1
Quantity of
Graph 4
A Contractionary Monetary Policy
15
The Fed will generally pursue a contractionary monetary policy when it considers inflation a
threat. In Figure 2 of Graph 4, the economy has an inflationary gap Y1-. A contractionary
monetary policy will attempt to close this gap by shifting the LM curve to LM1. In the money
market, shown in Figure 1 of Graph 4, the Fed sells securities, leaving the public with less
money, therefore shifting the money supply curve to the left and raising the interest rates on
securities, from r0 to r1. To carry out a contractionary policy, the Fed sells securities, mainly
bonds in the bond market, shown in Figure 3 of Graph 4, the supply curve shifts to the right,
lowering the price of these securities, from P0 to P1. As shown in the exchange market, Figure 4
of Graph 4, the higher interest rate induces a greater demand for domestic currency [dollar] as
foreigners seek greater benefits of higher interest rates in the United States. The supply of dollars
falls; people in the United States are less likely to purchase foreign assets now that U.S. assets
are paying a higher rate. The demand for foreign currency [peso] will fall. Thus domestic
currency [dollar] will appreciate in value relative to the foreign currency [peso], from E0 to E1.
Works Cited
Abel, Andrew B., Ben S. Bernanke, and Dean Croushore. Macroeconomics. 8th ed. Boston:
Pearson, 2014. Print.
16
Hernndez-Murillo, Rubn. "Experiments in Financial Liberalization: The Mexican Banking

Sector." The Federal Reserve Bank of St. Louis REVIEW September/October 2007. The Federal
Reserve Bank of St. Louis. Web. 4 Mar. 2015.
<http://research.stlouisfed.org/publications/review/07/09/HernandezMurillo.pdf>.
Kaplan, Jay. "The 1994 Mexican Currency Crisis." Economics: University of Colorado Boulder.
9 Jan. 1998. Web. 3 Mar. 2015.
<http://www.colorado.edu/economics/courses/econ2020/6550/readings/Mexico-currency.html>.
Springer, Gary L, and Jorge L. Molina. "The Mexican Financial Crisis: Genesis, Impact, and
Implications." Journal of Interamerican Studies and World Affairs Vol. 37.No. 2 (1995): 26.
Center for Latin American Studies at the University of Miami. Web. 1 Apr. 2015.
<http://www.jstor.org/stable/pdf/166271.pdf?acceptTC=true>.
Truman, Edwin M. "The Mexican Peso Crisis: Implications for International Finance." Federal
Reserve Bulletin, 1 Mar. 1996. Web. 13 Mar. 2015.
<http://www.federalreserve.gov/pubs/bulletin/1996/396lead.pdf>.
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Alejandro Lopez Rangel