Reference no: EM131044013

Mexico Peso Crisis

The crisis began on December 20, 1994 when the newly inducted President Ernesto Zedillo stated that the Mexican central bank's depression of the peso was between 15% and 13%. Peso devaluation at this time after preceding promises failed to do so caused investors to be emerge skeptical of the policymakers and were afraid of further devaluations. The investors resorted to foreign investments as well as placing even higher risks on premier on domestic assets. The foreign investors expecting further devaluations of currency started to rapidly withdraw their capital from the Mexican investments. Also, they sold off stock shares as the MSE (Mexican Stock Exchange) plummeted. The Mexican central bank started to raise interest rates in order to fight the capital flight. Higher borrowing costs, however, ultimately barred prospects of economic growth.

When it was time for the country to roll over its maturing debt responsibilities, a limited number of investors were interested in buying new debt. In order to repay tesobonos, the CBM had limited option but to buy dollars using its severely weakened currency. This turned out to be extremely expensive. As a result, the Mexican government faced a massive sovereign default.

The peso was allowed to float on December 22 by the Mexican government. The repercussion was that the peso depreciated by another 15%. The peso depreciated by approximately 50% to 7.2 MXN/USD from 3.4, recovering merely to 5.8MXN/USD after a period of four months. Prices of commodities in Mexico increased by 24% over the same period of four months. By the end of 1995, the country's hyperinflation had hit the 52% mark. The mutual funds invested in more than $45 billion worth of the country's assets in the many years leading up to the peso crisis, started liquidating their stances in Mexico as well as other developing nations. Not only did foreign investors leave Mexico, but also other emerging economies in general. This crisis led to a financial contagion throughout financial markets in Latin America and Asia. The outcome of Mexico's peso crisis on Brazil and Southern Cone became popularly known as the "Tequila effect" or efecto tequila.  Finally, in the impact of the peso crisis, several banks in Mexico collapsed amidst the extensive mortgage defaults. Mexico's economy underwent a severe poverty, unemployment, and recession.