Mexican Peso Crisis: Irregularities of Deregulation

Gonzalo Arenas


It is one thing to liberate an economy or a market; it is another to lift all regulations on such market. Economic liberalization should be done in an appropriate, intelligent manner. The lack of proper regulation can lead to a snowballing effect where a seemingly trivial matter can lead up to a terrible outcome. This was the case of Mexico in 1994 where birth was given to the “Tequila Effect”. What were the conditions in the country that gave way to this crisis? Could the crisis have been avoided? Perhaps under a more strictly regulated economy Mexico’s financial crisis could have been prevented, and if not, it could have been toned down in severity. The government’s decision to liberalize the country intended well, but was poorly engineered and therefore became an uncontrollable Leviathan that took its toll on the country as a whole.

Leading up to 1994 Mexico seemed to be miraculously rising from its crippled past of inflation and instability, to become a shinning beacon for the rest of Latin America. It was the example to be followed and the cause for much excitement among the players in the financial markets.  This phenomenon was known as the “Mexican miracle” and had been led by President Carlos Salinas de Gortari; a firm believer in neo-liberalization policies, and also the man who tackled inflation through a rigid fiscal and monetary policy, while strongly holding the exchange rate pegged at an average of 3.1 pesos to the dollar[1]. The new conditions of the Mexican economy were looked upon favorably by potential investment, and the stability it provided at home was very popular among the domestic population.

[1] Froot, K and Mathew McBrady, “The 1994-95 Mexican Peso Crisis”, HBS Case No. 9-296-056 (Boston: Harvard Business School Publishing, 1996), 3


However the reforms did not stop there. It is questionable whether it was appropriate or not to go ahead with so many changes in the economic structure all at once. Privatization of state-owned firms, including the bank sector, took place, and plus the country opened up to investment from abroad both in the form of direct as well as portfolio investment [1]. For the first time in history, foreigners were allowed to hold Mexican government bonds and shares in private companies. Suddenly, Mexico became the recipient of massive capital inflows[2]. Between 1990 and 1993 Mexico received a total of $91 billion in overall investment; of that total 67% was in the form of short-term portfolio investment while the rest was in the form of foreign direct investment[3].

[1] Froot, K, “The 1994-95 Mexican Peso Crisis,” 2

[2] Froot, K, “The 1994-95 Mexican Peso Crisis,” 8

[3] Froot, K, “The 1994-95 Mexican Peso Crisis,” 2


But all was not well. A series of unexpected events, and poor foresight led to the eventual collapse of the system. Politics, it seems, was the driving force for many of the policies being implemented. Mexico was adopting a firm stance on its exchange rate to increase investor confidence and to tackle inflation, but more importantly, to look reasonably stable in order to be able to join the Organization for Economic Co-operation (OECD)[1] which fell smoothly in line with President Salinas’ neo-liberal strategy. This exchange rate situation left the peso overvalued vis-à-vis the dollar. The overvaluation led to a chain reaction, which culminated with the devaluation of the peso. This, in turn led to massive capital flight. To better understand the events that led to these conditions, let us start with the effects of an overvalued currency on the economy.  Perhaps the first element of the sequential list is the fact that Mexican exports became expensive while imports were cheap[2]. Mexicans were finally able to import many foreign goods, which resulted in a current account deficit. Officials declared a lack of concern for the deficit stating that the high level of capital inflows more than made up for the losses made in the deficit[3]. Meanwhile, the interest rate kept increasing, putting pressure on the exchange rate to devalue. The central bank would respond by decreasing the money supply, and the government would respond by reducing government expenditure. Clearly, the government was neglecting growth in the name of inflation and its pegged exchange rate. Furthermore, the increasing interest rate made investors more attracted to buying government bonds, especially because the government was so committed to defend its exchange rate[4]. With this, the central bank’s liabilities increased, while it quickly lost foreign reserves given its need to keep up with the increasing interest rate.

[1] Sebastian Edwards, “Bad Luck or Bad Policies? An Economic Analysis of the Crisis,” in Mexico 1994: Anatomy of an Emerging –Market Crash, ed. Sebastian Edwards and Moises Naim (Washington, D.C: Brooking Institution Press, 1997), 105

[2] Lustig, Nora, “Mexico the Remaking of an Economy,” 2nd ed. (Washington, D.C: Brookings Institution Press, 1998) 147-151

[3] Rogelio Ramirez de la O, “The Mexican Peso Crisis & Recession of 1994-1995: Preventable Then, Avoidable in the Future?” in Mexican Peso Crisis, ed. Riordaon Roett (Boulder: Lynne Rierner Publisher Inc, 1996) 18

[4] Rogelio Ramirez de la O, “The Mexican Peso Crisis & Recession of 1994-1995: Preventable Then, Avoidable in the Future?”, 12-15


Eventually fiscal policy was loosened in order to provide a slight degree of growth[1]. After all, elections were coming around and it was a good move to get people’s spirits up. The peso was allowed to devalue within its pre-determined band, but investors began to get suspicious and the Mexican central bank was quick to sense the sudden lack of trust. In a final act, pursuing an increase in investor confidence, the Mexican Central Bank offered to convert all previous government bonds (cetes) into new dollar-denominated bonds (tesobonos)[2].  This move eliminated any peso related risk for the investors and passed the risk on to the central bank, which would have a tough time paying up if the peso were ever to be devalued.

[1] Rogelio Ramirez de la O, “The Mexican Peso Crisis & Recession of 1994-1995: Preventable Then, Avoidable in the Future?”, 12-15

[2] Manuel Pastor Jr. “Pesos, Policies, and Predictions,” in The Post NAFTA Politcal Economy: Mexico and the Western Hemisphere, ed. Carol Wise (University Park: Pennsylvania State University Press, 1998), 125-127


As was mentioned before, President Salinas decided to liberalize the economy all at once. While all this activity was going awry in the financial arena, the privatization of banks had also resulted in a less than desirable situation. The Mexican government had pursued a privatization strategy that would provide it with the most amount of revenue. In other words all of the firms, when sold, were priced higher than their actual worth, including the banks. Once privatized, in an effort to make up for the losses, the new bank owners were forced to make high-risk loans, especially because of the fact that the country was experiencing such low levels of growth. Ironically enough, later on when the whole system crashed, the government was forced to rescue the banking sector by providing it with subsidies. It is more than probable that the cost of rescuing exceeded the gains from privatizing [1].

[1] Rogelio Ramirez de la O, “The Mexican Peso Crisis & Recession of 1994-1995: Preventable Then, Avoidable in the Future?”, 22


The final coup-de-grace came when the new president, Ernesto Zedillo, having seen the loop the Mexican economy had gotten itself into, saw no other choice but to widen the band within which the exchange rate would be allowed to float. On December 19, 1995 the upper limit of the band was widened 15%[1]. As if investor confidence wasn’t already lingering on the low, this last move got money flowing violently out of the country. Two days later, the exchange rate was allowed to float freely[2]. In a sense, it was Zedillo’s devaluation that triggered it all. 

With the facts at hand it is easier, through hindsight, to understand the situation Mexico was living back in the early 90’s. It might be said that Mexico was attempting to use speculation to its advantage. Which came first, the chicken or the egg? Which came first, growth in Mexico or high levels of investment? In other words, was it growth in the economy that brought in high levels of investment, or was it high levels of investment that brought growth in the economy? Investors saw in Mexico a new oasis for investment where the situation seemed risk-free enough to be lucrative. However it is probable that the growth that investors were witnessing was nothing more then their own creation. All the government did was set the gears in motion with its desire to liberalize, form a part of NAFTA, allow foreign money into Mexican financial markets, and pegging the exchange rate. The rest was a self-fulfilling prophecy led by investors who began it by purchasing Mexican stocks and bonds. This resulted in growth, so investors invested more money, which resulted in more growth, and so on. The ease with which investors were allowed to bring money into the country was the factor that blew the whole situation out of proportion, for money that can come into the country quickly can also leave just as quickly. What was called “the Mexican Miracle” was nothing more than a façade designed to bring investment into the country.

[1] Rogelio Ramirez de la O, “The Mexican Peso Crisis & Recession of 1994-1995: Preventable Then, Avoidable in the Future?”, 11

[2] Manuel Pastor Jr. “Pesos, Policies, and Predictions,” 127


The increase in capital inflows gave way to a consumption boom, but very short levels of savings[1]. Furthermore, the capital inflows were not in the form of direct investment (such as infrastructure, construction of factories, etc.), but more in the form of short-term, highly liquid portfolio investments in the Mexican stock market. The country seemed to be doing great, people were ecstatic with their sudden increased capacity to consume and investors further invested. But this system provided no present real growth and no investment for future growth. When President Zedillo decided to devalue the currency, the massive quantity of money that had made Mexico seem so fruitful, quite suddenly left the country. The illusion ceased to exist and the cruel reality sunk in, magnified by the grave disappointment and the lowest level of investor confidence in years. Had the money not been allowed to enter with such ease, investors would have perhaps behaved more cautiously from the start. Not just that, but the magnitude of the problem would have been reduced.

[1] Sebastian Edwards, “Bad Luck or Bad Policies? An Economic Analysis of the Crisis,” 106


The case of Chile is a good example of what Mexico should have done. In Chile there was a special tax that would gradually decrease, the longer capital stayed within the country.  They also employed a higher than average minimum bank reserve for money being loaned to foreign investors[1]. Sure this type of policy would reduce the amount of investment, but it would have been a disincentive for investors to pull their money out of the country so quickly, while being an incentive for the investors to tread much more cautiously then they did in Mexico. In Chile, interestingly enough, these policies did not slow the growth rate[2]. Mexico, in its desire to attract investment, tried to reach its final goal without going through the necessary steps in the way. It tried to hop from A to C without going through B. What would be of Mexico today had things been managed differently in 1994? It is hard to say, however it is quite evident that had the financial markets been more strictly regulated, a more reduced ratio (a healthier ratio) between portfolio investment and foreign direct investment would have resulted, providing higher levels of real growth. It is preferable to have a reduced amount of capital inflows that are manageable, then a massive quantity of inflows that prove to be unsustainable, uncontrollable and unpredictable. Unsustainable, because of the rising interest rate, which forced the central bank to sell foreign reserves, thus making it impossible to pay back its debt. Uncontrollable, for the market was unregulated and the investment was mostly short-run, lower risk, and higher liquidity. Unpredictable because it is hard to know what people will do in the future. Speculation is useful but not always accurate.

[1] Froot, K, “The 1994-95 Mexican Peso Crisis”, 8

[2] Froot, K, “The 1994-95 Mexican Peso Crisis”, 8


Chile proves that it is better to have lower levels of inflows that are constant, then erratic larger inflows that either way, eventually drain out of the country. The policies adopted in Mexico were adequate for a developing economy. However the process should have been done as painlessly as possible, especially considering the fact that those who take the strongest blow are the lower echelons of society who have a more reduced ability to adapt to the changing system given their lower levels of income and skills. Perhaps, back then, Mexico needed to maintain a pegged exchange rate. A pure economic model is a concept that is unrealistic in today’s world. Political factors carry a great deal of weight and Mexico would have never been able to become trading partners with Canada and the U.S.A. under NAFTA if its inflation level wasn’t quickly reduced, and its exchange rate didn’t seem stable. President Salinas tried to do a great deal of positive things for Mexico, but he was too greedy. The privatization process could have waited, and the restructuring of the financial markets should have provided a greater incentive for long-term investment in the country. This would have resulted in real growth, allowing the banking sector to provide loans without getting involved in high – risk endeavors.

Neo-liberalization takes its toll on society. Developing countries that have adopted this strategy, such as Mexico, show difficult transition periods where adjustments are gradually made. The system cannot change from one day to another. The macroeconomic variables (prices, wages, inflation, etc.) have to be given the opportunity to reach their new equilibrium level. In a sense, the adjustment process is like a vaccine given to a patient to get better. However, if the vaccine is too potent, and the patient too weak, the possibility of killing the patient is very high. Mexico was still a weak patient back in the early 90’s. The most adequate vaccine would have been a milder one. The adjustment process would have taken longer, but the shock would have been inferior. Had the Mexican government allowed for higher regulation on the financial markets, it would have had the opportunity to deregulate sometime in the future, after the bulk of the adjustment had taken place, and thus have had a certain degree of inertial growth ahead of it. In theory, equilibrium would have been achieved among the majority of the macroeconomic variables and Mexico would have truly been a wonderful place in which to invest with only good times to look forward to.


Mexico’s crisis has been the subject of much research. Economists, politicians and sociologists have all done their very best to try and determine the root of the crisis. Many different theories have arisen, but none of them seem to agree on the underlining cause. Some give more weight to the pegging of the exchange rate, others blame the political environment in the country, and yet others blame it on NAFTA. Ironically enough, whatever the research concludes is obsolete altogether. It is naïve to consider that any other situation in the future can relate to the Mexican crisis, or any other crisis for that matter. The causes and consequences will never be the same. Therefore, what we learn here is fairly useless elsewhere. One should approach the data with caution and take from it, not the raw information, but the overall lesson. economics is a science haunted by its inability to experiment in a laboratory. Therefore there is so much we don’t know and understand about it. The whole picture is yet to be grasped, however different approaches to parts of the whole, such as the Mexican crisis, should be observed and studied with hopes that with this knowledge a clearer grasp of the whole can be reached. Perhaps in understanding a broad scope of individual “case studies” a common factor can begin to be found, and with that, a piece of the puzzle put in place. To regulate or not to regulate? The balance tilts both ways. However, Mexico’s case screams for regulation. Either way, elsewhere or under different conditions, regulation might be the most inadequate of strategies. Most everything in this life is relative; this question proves not to be the exception. Attempting to grasp the whole all at once is a task too difficult to tackle, so it is wise to focus on the part. Mexico’s case has been so readily studied because it is so helpful in learning more about the whole. The complex dance that the macroeconomic variables performed ensued a crescendo, which climaxed with capital flight. Perhaps there is still more to be learned from Mexico’s experience. Hopefully the experience, which resulted in the strife, hunger and shock felt by so many Mexicans, will serve as a stepping-stone in the pursuit for greater economic understanding. In the end the real question at hand is, will the lessons learned today still apply tomorrow? I guess we will have to wait and see.



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