Currency Devaluation and the causes of the Tequila Crisis

Question

I was reading about some of the famous crisis that happened in the past and i came across "the tequila crisis" in mexico during 1994-96.

As a background, The Tequila crisis (also known as the Mexican Peso Crisis or December mistake crisis) was a currency crisis sparked by the Mexican government's sudden devaluation of the peso against the U.S. dollar in December 1994, which became one of the first international financial crises ignited by "capital flight", as investors pulled out of Mexico.

The extended issuance of Tesbonos, a mexican bond also contributed to the crisis

What are the mechanisms for a currency devaluation in a case like this?

Answer 1

The Mexican government has a complicated history of currency intervention, which can be read about in a detailed timeline here.

However, in 1994 the devaluation was caused by the end of government intervention. Up until that date the Mexican government had a set range of USD values that the peso could float within, so a sort of flexible peg to the USD. In December of 1994 the government decided to allow the peso to float freely and the peso was devalued naturally through market forces.

Answer 2

Currency crises of this sort have happened many times.

A) Typically a country (its government or central bank) decides that, in order to have stability and attract foreign capital, it will tie the value of its currency to another currency, typically the US dollar. It fixes the price between local and foreign currency. This is great for anybody that is thinking of holding on to local currency assets because it reassures you that its value won't change suddenly. (Mexico decided to fix the peso price to about 3 pesos per dollar or so.)

B) In many of these crises, what happens is that, because of inflation, or because of foreign demand for local assets, the price chosen by the government for the local currency in terms of the local one becomes unrealistic. Goods at home get to be very expensive compared to foreign goods, so the country starts buying more and more foreign goods, or the firms start borrowing more and more foreign capital. This 'borrowing' is tracked the the current account. The current account deficit of Mexico was large and growing before the crisis, on the order of 10-20 billion dollars a year. Moreover, as was the standard at the time, it had borrowed from foreigners in dollar-denominated terms through the Tesobonos. foreigners would not buy peso-denominated debt...

C) This imbalance between the local demand for foreign goods (or capital) and foreign demand for local goods or capital, would lead toa currency depreciation, through basic demand and supply equilibrium. Instead, when the country has a fixed exchange rate, the imbalance implies that the central bank has to sell its reserves of foreign currency to keep the price of the local currency fixed. The central bank of Mexico sold about 30 billion dollars of assets into the peso-dollar market to try to keep the price fixed in late 1994.

D) At some point, investors, speculators, citizens, etc. realize that there is an imbalance and things might end up badly. Therefore, they see that the local currency could change in price soon!! This makes them all try to buy foreign currency with local currency at the same time, to be protected! But the central bank does not have enough foreign reserves to keep the price fixed in the face of such demand, so it has to accept a change in the price of the local currency. Kaboom! After the large fall in reserves in the Mexican central bank, the government accepted that it would be impossible to keep the currency fixed and let it float - let the market determine its price. The peso changed in price from 3.5 per dollar to 7.5 in a few months, settling around 6.