Mexico Financial Crisis of 1994: The Tequila effect
The ‘Tequila Effect’ was the informal name given to the impact of the 1994 Mexican economic crisis in the South American economy. The tequila effect occurred due to a sudden devaluation of the Mexican weight, which caused the decrease in other coins in the region (the Southern Cone and Brazil). It is also known as the ‘Mexican shock’. The weight drop was underpinned by a rescue package of $ 50 billion coordinated by the then president of the United States, Bill Clinton, and administered by the International Monetary Fund (IMF).
On December 20, 1994, the Mexican Central Bank devalued the weight between 13 and 15 percent. To limit excessive capital leakage, the bank also increased interest rates. Short -term interest rates increased to 32 percent, and the highest costs resulting from loans represented a danger to economic stability. The Mexican government allowed the weight to float freely two days later, but instead of stabilizing, the weight received another strong blow, devaluing almost half of its value in the following months. Immediately after the Mexican weight was devalued in the first days of the presidency of Ernesto Zedillo, the South American countries also suffered a rapid depreciation of the currency and a loss of reserves. Foreign capital not only fled from Mexico, but the crisis also caused financial contagion in emerging markets. It was a known fact that the weight was overvalued, but the scope of Mexico’s economic vulnerability was not well known. Since governments and companies in the area had high levels of debt called in US dollars, the devaluation meant that it would be increasingly difficult to pay the debts.
In response to the crisis, the United States Congress approved the 1995 Debt Dissemination Law, which was promulgated by President Clinton on April 10, 1995. The law provided billions in financial assistance for exchange facilities and securities guarantees using US taxpayers dollars, and more assistance provided by the IMF. The Mexican government, as a condition of considerable rescue, was obliged to implement certain controls of fiscal and monetary policies. They also took care to maintain their existing commitments with the Policies of the North American Free Trade Agreement (NAFTA). Mexico suffered a severe recession and episodes of hyperinflation in the years after the crisis, since the country maintained excessive levels of poverty during the rest of the nineties.
There are two key differences of industrialized countries in the institutional structure in emerging market countries, such as Mexico, it is a clear example, which makes a big difference in the dynamics of banking and financial crises. Private debt contracts have a very short duration. Many debt contracts are called foreign currencies. For example, in emerging market countries such as Mexico, private debt contracts are revalued at least once a month, so the duration of this debt is very short. On the contrary, private debt contracts in industrialized countries such as the United States are much longer, with durations that are commonly extended to many years. An important reason why this happens is that emerging market countries have experienced very high and variable inflation rates, so the risk of inflation in long -term debt contracts is extremely high in relation to which it is locatedIn industrialized countries. Short -term debt contracts then dominate because they carry much less inflation risk. High and variable inflation is also a driving force behind the second institutional characteristic of financial markets in emerging markets. High and variable inflation leads to a tremendous uncertainty about the future value of national currency in emerging markets. Therefore, many non -financial companies, banks and governments in emerging market countries and it is much easier to issue debt if it is called in foreign currencies. This was an outstanding feature of the institutional structure in Chilean financial markets before the financial crisis in 1982 and in Mexico in 1994.
The first involvement is that, in contrast to what happens in most industrialized countries, in emerging market countries, an important trigger is an important trigger that leads to a financial crisis. To see this, we must understand what a financial crisis is about. In recent years, a modern and asymmetric theory of financial crisis theory has been developed. The basic idea of this theory is that a financial crisis is a situation in which information flows in financial markets are interrupted so that financial markets cannot do their job: that is, financial markets can no longer channel funds from funds fromefficiently to those who have more productive investment opportunities. When this happens, the result is a strong fall in investment, both companies and homes, and a strong contraction of economic activity.
So how does an exchange crisis lead to a financial crisis? With debt contracts called foreign currency, when there is a great depreciation or unforeseen devaluation of the national currency, the burden of debt of national companies triggers sharply. Since the assets of these companies are generally called in national currency, there is no equivalent increase in the value of assets when the value of liabilities increases, so there is a strong deterioration of companies’ balance sheets and a great decreaseIn the Net Heritage. When companies have less net assets, asymmetric information problems in financial markets increase and can lead to a financial crisis and strong contraction in economic activity.
There are several reasons why the decrease in net worth derived from a exchange crisis can cause a financial and depression crisis. First, net assets play a role similar to that of guarantee that helps reduce adverse selection problems in credit markets. If a ®RM has a decrease in net assets, lenders have less to grab if the company does not meet its debt and, therefore, will not want to lend it. In addition, with less net assets, it is more likely that a company fails because it has a smaller asset mattress that you can use to pay its debt. An even more important reason why companies will have less access to credit when their net assets deteriorates is that a decrease in net assets increases incentives for companies to participate in a moral risk. Less net estate means that companies now have less at stake and, therefore, less than losing if they do not comply with their loans.
Therefore, the incentives for them to assume a lot of risk become very high. The most extreme case of this moral risk occurs when net assets decreases so much that a company is insolvent. Then the company has huge incentives to make great bets with the hope of leaving the hole. Therefore, lenders have an additional reason to avoid loans to companies when their net worth decreases.
An exchange crisis can also precipitate a bank crisis, with additional devastating effects on the economy. The fact that private debt is often called in foreign currency in emerging market countries is key to understanding how an exchange crisis helps to produce bank crises that are so harmful to these countries.
Due to the prudential regulations that force banks to equal. 3 However, this is not the case. While the correspondence of assets and liabilities called abroad makes it seem that banks have no market risk due to changes in the exchange rate, in effect they do so. When a devaluation occurs, although it seems that the value of the assets called abroad increases to match the increase in liabilities called abroad, it does not do so. In emerging market countries such as Mexico, assets called foreign currency of banks are usually loans in dollars to national companies. As we have seen, when there is a devaluation, companies with these dollars in dollars suffer a serious deterioration in their balance sheets because the value of their liabilities called foreign currency triggers, while the value of their assets called in national currency does not . The result is that these borrowers of the banks cannot pay their loans and, therefore, banks and as their liabilities called dollars increase in value, it is likely that their loans called dollars decrease. Therefore, the devaluation of the currency leads to a deterioration in the banks of the banks because the exchange risk for the borrowers becomes a credit risk for the banks that have granted loans called in foreign currency.
When banks suffer a deterioration in their balances as a result of a exchange crisis and, therefore, they have a substantial contraction in their capital, they have two options:
- They can reduce their loans to reduce their asset base and thus restore their capital ratios
- They can try to raise new capital. However, when banks experience deterioration in their balance sheets, it is very difficult for them to raise new capital at a reasonable cost.
Therefore, the typical response of banks with weakened balances is a contraction in their loans, which slows economic activity. However, if the deterioration of bank balances is serious enough, it can have even more drastic effects on bank loans if it leads to banking panics, in which there are multiple simultaneous bankruptcies of banking institutions. As, as we have seen, banks have a special role in the economy, the decrease resulting from bank loans after a collapse in the value of national currency leads to strong contraction in economic activity.
References
- Mishkin, f. S. (1999). Lessons from the tequila crisis. Journal of Banking & Finance, 23 (10), 1521-1533.
- Boughton, J. M. (2000). From Suez to Tequila: The Imf as Crisis Manager. The Economic Journal, 110 (460), 273-291.
- Of Gregorio, J., & Valdes, R. EITHER. (2001). Crisis Transmission: Evidence from The Debt, Tequila, and Asian Fl. In International Financial Contagion (pp. 99-127). Springer, Boston, Ma.
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