Lessons from the Past - The Tequila Crisis

The Tequila Crisis is a classic example of an emerging market financial debacle. After years of strong returns for equity investors, the Mexican currency and stock market crashed in 1994. An examination of the reasons for this crisis provides a number of lessons for equity investors today.

Glory days

After financial problems in the early 1980s, Mexico introduced economic reforms in the second half of the decade. Trade was liberalised by a rapid reduction of tariffs, and the banking sector was deregulated and privatised. The budget deficit1 fell, inflation declined and the economy boomed. This buoyant period culminated in the conclusion of the North American Free Trade Agreement (NAFTA), which eliminated most tariffs between Canada, Mexico and the US, and came into effect in January 1994.

As a result of the positive economic environment in Mexico, foreign capital flooded into the stock market which provided very high returns for investors year after year, including a rise of 118% in 1991.2

Exchange rate policy

Mexico had a history of balance of payment crises - there were depreciations of the peso in 1954, 1976 and 1982. As a result of the reform programme of the 1980s, the currency was pegged to the US dollar; a crawling peg3 allowing gradual depreciation, although in real terms4 the peso appreciated. This policy caused rigidity, however, especially as the economy boomed and sucked in imports, causing the current account deficit5 to rise from $2.4bn in 1988 to $29.4bn in 1994.6 This left the country susceptible to short-term capital flows.

US interest rates

An important factor precipitating the crisis was a series of US interest rate rises, month after month, in 1994.7 The pace of the tightening caught the market by surprise and resulted in strengthening of the US dollar, which put severe pressure on currencies like the peso, which were linked to it.

Political instability

1994 proved to be a year of political upheaval in Mexico. On 1 January, the Zapatista National Liberation Army launched a rebellion against the government in the southern state of Chiapas, with violence continuing throughout the year. On 23 March, Luis Donaldo Colosio, the ruling Institutional Revolutionary Party’s (PRI) presidential candidate, was assassinated. A wave of kidnappings of Mexican entrepreneurs occurred between March and September.8 In late September, Jose Massieu, the Secretary General of the PRI was also assassinated. On 23 November, the Deputy Attorney General resigned, alleging a cover-up of the murder of his brother Massieu, which intensified the financial crisis.

Capital flight9

A spike in risk aversion10, caused by political instability and rising US interest rates, resulted in capital flight from Mexico and pressure on the peso. On one single day, 18 November 1994, $1.6bn left the country, with $3bn departing over the month. In four weeks Mexico lost $11 billion in reserves.11 Pressure on the peg intensified to a critical level. Initially the central bank widened the trading band, but this had little impact.12

Devaluation

On 20 December, the Mexican government devalued the peso by 15%, but capital continued to leave the country. Between 20 and 21 December, $4.6bn left Mexico, almost half the remaining foreign exchange reserves. On 22 December, Banco de Mexico withdrew from the foreign exchange market, allowing the peso to float. The Mexican stock market dropped two-thirds in dollar terms between 19 December 1994 and 9 March 1995 when it bottomed.13 Contagion spread to other emerging stock markets, particularly Brazil and Argentina, which fell steeply, raising concerns about a broader emerging market crisis.

Bail-out

On 11 January 1995, President Clinton announced financial support for Mexico. A credit line of $50bn was established with the US Treasury providing $20bn, the International Monetary Fund $18bn, the Bank of International Settlements $10bn and private banks the rest. This helped Mexico avoid a sovereign default14 and marked the beginning of a return to financial stability, underpinned by further financial reforms in March 1995 as part of a stabilisation plan.

Banking crisis

The early 1990s also saw a lending boom in Mexico. Bank liberalisation encouraged excessive risk-taking by banks with expansion into consumer loans and mortgages, as well as borrowing in US dollars.

Interest rates rose steeply during the crisis and pushed the economy into deep recession. In 1995, GDP15 shrank by 6.2% and real wages fell by about 20% in the wake of the crisis.16 Bank defaults spiked17, causing the worst banking crisis in Mexican history (1995-7).

Ultimately, new banking legislation introduced in 1997 allowed foreign investors to gain control of Mexican banks. By 2008, foreign banks controlled 80% of the assets in the commercial banking system.

Lessons for Investors

At Stewart Investors we are bottom-up investors18, focusing on companies. However, this does not stop us considering important macro developments.

In many ways the Tequila Crisis is a classic example of an emerging market boom and bust, highlighting the susceptibility of countries to capital flows and the risks of foreign currency debt under a fixed exchange-rate regime.

The Tequila Crisis also shows the risks that banks take during a boom. Inherent systematic risk, leveraged financial structures and opacity19, make banks particularly risky investments.

The importance of identifying quality company management is paramount to our investment process. We believe that investing in companies run by good stewards, who will not be influenced by the excesses of the boom or the despair of the bust, is the best way to provide long-term returns for investors.

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Footnotes

  1. A budget deficit is the difference between government expenditure and the amount raised by taxation.

  2. Musacchio, Aldo. “Mexico’s Financial Crisis of 1994-1995.” Harvard Business School Working Paper, No. 12–101, May 2012. Stock market returns were as follows: +71.1% (1989), +34.6% (1990), +118.3% (1991), +21.2% (1992) and +48.4% (1993).

  3. A crawling peg is a currency arrangement which allows for gradual movements up or down of the currency within broader limits.

  4. Taking account of inflation.

  5. A current account deficit is when the value of the goods and services exported by a country is less than the value of goods and service imported.

  6. The Mexican Peso Crisis: Implications for International Finance. Source: https://www.federalreserve.gov/pubs/bulletin/1996/396lead.pdf
  7. The Federal Reserve moved into tightening mode with increases in February, March, April, May, August and November.

  8. Musacchio, Aldo.

  9. Capital flight is when money leaves a country on concerns about political or economic risk.

  10. Risk aversion describes the propensity for investors to move into less risky assets, such as cash and bonds.

  11. Joseph A. Whitt, Jr., The Mexican Peso Crisis, 2.

  12. Musacchio, Aldo.

  13. The Mexican Peso Crisis.

  14. A sovereign default is where a country cannot meet its interest payments on its debts.

  15. GDP stands for Gross Domestic Product which is a measure of the productive capacity of an economy.

  16. Economist, Tequila slammer, 29 December 2004.

  17. A bank default is a loan where the borrower is unable to make repayment to the bank.

  18. ‘Bottom-up’ investors focus on the company level, rather than broader sectoral or country analysis.

  19. Leveraged financial structures involve high levels of debt relative to capital and opacity refers to a lack of transparency.