What Is The Tequila Effect?
The Tequila Effect (also known as "Tequila Shock" or the "Tequila Crisis") is a slang term for financial or economic fallout resulting from the Mexican economy.
The Mexican peso (MXN) has been the official currency ofMexicosince 1861, forty years after the country gained its independence. The 1994 Mexican currency crisis was a sudden devaluationofthe Mexican peso, whichcaused 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 "Tequila Effect" or the "Tequila Shock."
The falling peso was eventually propped up by a $50-billion bailout package coordinatedby then U.S. President Bill Clintonand administered by the International Monetary Fund (IMF).
Key Takeaways
- The Tequila Crisis began onDec. 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, theMexican central bank devalued the peso by 15%. To limit the excessive flight of capital, the bank also raised interest rates. Short-term interest rates rose to 25 percent, and the resulting highercosts of borrowingwere a danger to economic stability.
The Mexican government allowed the peso tofloatfreely again two days later, but rather than stabilize, the peso took another sharp hit, depreciatingnearly 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 depreciationand a loss of reserves.Foreign capitalnot only fled Mexico butthe crisis led tofinancial contagionin 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 theMexican Debt Disclosure Act of 1995, which was enacted by President Clinton on April 10, 1995. The law provided billions in financial assistance forswap 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 requiredto implement certainfiscal and monetarypoliciescontrols. They were also carefulto maintain theirexisting commitments to policies of theNorth 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.
