The Great Default That Never Was — Mexico’s Tequila Crisis

The Great Default That Never Was — Mexico’s Tequila Crisis

By Alonso Garza

Hooded Zapatista rebels and their supporters march down Mexico City's main avenue, the Paseo de la Reforma, Friday Sept. 12, 1997. The Zapatista movement rose up on New Year s Day 1994.
SourceJose Luis Magana/AP


Because manufacturing economic stability often contains the seeds of its own destruction.

Alonso Garza

Alonso Garza

It was cold in Mexico City that holiday season. My family had flown in from Monterrey to spend New Year’s 1995 with my cousins, and we were staying at my uncle’s house. One morning, I walked downstairs to find my father with a tense look on his face. “Forty-five percent in one week!” he said to my uncle. “That’s all it took. One week for our net worth to be slashed in half!”

I was old enough — 18 — to know exactly what they were talking about. Mexico, the country that once was touted as an economic model for the world’s emerging markets, had been forced to “float” the peso and allow it to devalue. What came to be known as the Tequila Crisis was unleashing a savage lesson upon Mexico and the international investing community.

That night, Zedillo had no choice but to allow the peso to float.… The Mexican economic miracle had come to an ignominious end.

In July 1988, when Carlos Salinas de Gortari was elected president of Mexico, he set about crafting aggressive pro-business policies that rapidly transformed Mexico’s economy. Between 1987 and 1993, government revenue increased by nearly 600 percent, the federal budget swung from a deficit of 14.2 percent to a surplus of 0.5 percent and inflation plummeted from a wild 159 percent to 8 percent. “Wall Street and London brokerage houses were pressing their clients to buy as many Mexican stocks as they could and take advantage of the economic miracle led by Mexico’s young president,” writes Andres Oppenheimer in Bordering on Chaos: Mexico’s Roller-Coaster Journey Toward Prosperity.

How did Salinas achieve such drastic improvements? By manufacturing economic stability.


In an effort to attract foreign capital, Salinas embarked on a program called El Pacto (the Pact), which involved a two-pronged strategy: Lower inflation with an agreement between government, business, farmers and labor unions that artificially set prices and wages; and maintain a steady exchange rate by requiring Mexico’s central bank (Banxico) to use its dollar reserves to maintain the peso within an agreed-upon trading band.

Although there were some skeptics, investors generally believed that the government would be able to deal with events that might threaten El Pacto. But toward the end of 1993, unforeseen circumstances began to exact their revenge.

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People line up at the money exchange in Mexico City’s airport on Jan. 13, 1995. The Mexican peso ended a crisis week at 5.30 per dollar after trading from 5.20 to 6.00 per dollar. 

Source JORGE SILVA/Getty

Mexico’s growth had benefited the business community, but the rural sector remained in dire poverty, causing social tensions to rise. On Jan. 1, 1994, a mysterious figure with the nom de guerre Subcomandante Marcos emerged from the jungles in the southern state of Chiapas, leading a ragtag group of farmers. The government reacted quickly to what became known as the Zapatista rebellion by sending in federal troops — crisis averted. But nervousness began to materialize.

Those anxieties were soon heightened. Luis Donaldo Colosio, the presidential candidate of the PRI, the party that had ruled Mexico for seven decades, was virtually guaranteed to replace Salinas as Mexico’s next president in the August elections. But on March 23, Colosio was shot in the head and killed while campaigning in Tijuana. Panic erupted, and investors began to pull capital out of the country, forcing Banxico to use dollar reserves to maintain the peso within its trading band. 

Six days later, the PRI announced that Ernesto Zedillo was its new presidential candidate. His appointment appeased the investor community, helping stabilize capital outflows. As expected, Zedillo won the election in August and was set to be sworn in on Dec. 1.

Then, more turmoil. On Sept. 28, Jose Francisco Ruiz Massieu, secretary-general of the PRI and brother-in-law of outgoing President Salinas, was brutally murdered. Investor concerns flared, and once again the central bank had to furiously defend the peso.

After Colosio’s assassination, Banxico’s dollar reserves dropped by about 36 percent, from $25 billion to $17 billion. After the Ruiz Massieu murder, reserves dropped by an additional 58 percent, down to a mere $7 billion. Without dollars, Mexico could not function, and when word leaked out about fading reserves, fear tightened its grip around investors’ throats.

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An American shopper taking advantage of the devalued peso returns to the U.S. from Mexico at the border crossing in downtown Nogales, Arizona, in February 1995.


Finally, in what seemed to be a cruel cosmic conspiracy against Mexico, on Dec. 19, Subcomandante Marcos launched a second counteroffensive in Chiapas.

That night, Zedillo had no choice but to allow the peso to float. The next day the currency depreciated by nearly 14 percent, and seven days later, my father remarked: “Forty-five percent in one week!” The Mexican economic miracle had come to an ignominious end.

After months of negotiations, Mexico received a $50 billion emergency loan from the U.S., the International Monetary Fund and other financial institutions. Without it, Mexico would have defaulted on its dollar obligations, potentially sending the entire region into an economic tailspin. Martin Castellano, deputy chief economist for Latin America at the Institute of International Finance, explains: “The Tequila Crisis was a key event for the region due to financial contagion, particularly in countries with very rigid monetary schemes such as Argentina. In fact, policymakers in Latin America started to wonder after the Mexican crisis about the cost and benefits of fixed exchange rate regimes and the best ways to preserve financial stability.”

The Tequila Crisis became the great default that never was.

In retrospect, manufacturing economic stability is a tantalizing proposition, but one that often contains the seeds of its own destruction. Mechanisms used by governments to diminish economic or financial risks essentially propose a paradigm that does not exist, in the hope that reality will eventually merge with this desired new state. But reality is tenacious.

Mexico faced massive shortcomings such as social inequality and rampant corruption. Suppressing inflation and manipulating the currency were not going to solve those issues. Thus, instead of reality bending to the will of the government, it was the government that ended up bending to the will of reality.

Today, the best example of manufactured economic stability is China, which is running a similar experiment, albeit on a massive scale. China would be wise to heed the lessons of the Tequila Crisis.