An example of hidden sources of fragility in the context of the Mexican Tequila Crisis. Key learning: “there is often an unknown vulnerability that only comes to light when a crisis erupts”
From Bamboo Innovator:
Tequila crisis: The dangers that only come to light in a disaster
Mexico’s “tequila crisis” is the quintessential example of the dangers of original sin. It also holds some cautionary lessons for those who believe the floating exchange rates and foreign borrowing abstinence of emerging markets will now inoculate countries from crises.
Money gushed into Mexico in the early 1990s but when Alan Greenspan, the Federal Reserve chairman, raised interest rates in 1994 the boom came to an abrupt end – and the dollar put pressure on the peso’s peg. By December the government tried to depreciate the peso but the currency crashed by more than 50 per cent.
The government was then brought low by its Tesebonos – peso bonds indexed to the dollar to reassure investors worried about a devaluation. When the peso collapsed the state was unable to pay the Tesebonos and had to be rescued by the US and the International Monetary Fund.
Today Mexico’s finances are transformed. About 80 per cent of its debts are in pesos, the currency floats and the central bank’s reserves are close to $180bn. Original sin is almost eliminated and the country is a firm investor favourite.
But the tequila crisis holds another vital lesson for policy makers and investors that draw comfort from the striking reduction in original sin: that there is often an unknown vulnerability that only comes to light when a crisis erupts.
Mexico’s crash in 1994 was exacerbated by the fact that the recently privatised local banks had themselves quietly accumulated huge exposures to Tesebonos. The currency devaluation therefore hammered the entire domestic banking sector instead of just hurting US banks, causing a ripple throughout Latin America.
Nor did Mexico look particularly vulnerable before the crisis struck. Although the current account deficit was wide and inflation elevated, the budget was not in terrible shape and growth was the fastest in four years in 1994. “Mexico was the poster child of Latin America,” says Prof Calvo. “But when liquidity bubbles burst it reveals weaknesses we cannot see now.”