The “Tequila Crisis” of 1994-1995, which originated in Mexico and spread to Brazil and Argentina, is one of the most significant events in emerging financial markets during the past two decades. Not only did the crisis interrupt the three most important liberalization experiments in Latin America at the time, it initiated a debate among economists and policy makers about the sources of financial fragility in emerging markets more generally, and about the possible need to redesign the so-called “global financial architecture” to make crises less likely. That debate has intensified in the wake of recent problems in Asia in 1997, and in Russia and Brazil in 1998.

One could argue that there was little that was new about the Mexican crisis. After all, the Chilean liberalization of the 1970s (the first of its kind) and its subsequent collapse in 1982-1983 shared much with the Mexican experience, and many other examples of similar phenomena can be found in the 1980s (Caprio and Klingabiel, 1996a, b; Lindgren et al., 1996). In both the Chilean and Mexican cases, exchange rates and banking systems collapsed together and banking system insolvency problems predated the collapse of the exchange rate peg. Exchange rate depreciation was enormous in both countries, and the insolvency of the banking systems was similarly large (roughly 15-20% of GDP in Mexico, and 25% of GDP in Chile). Sergio de la Cuadra, Chilean Minister of Finance at the time of its crisis, argues that the anticipated fiscal costs of the government bailout of insolvent firms and banks made the exchange rate peg unsustainable, and that exchange rate collapse deepened the fiscal costs of the government bailout, because of the currency risk exposure of banks and firms which had large net dollar liabilities (de la Cuadra and Valdes, 1992). A similar account is told in the case of Mexico by Garber (1997), Caprio and Wilson (1998), and Wilson et al. (1998). Imprudent and politically motivated lending, and costly off-shore exchange rate derivative exposures, bankrupted Mexican banks, providing the fiscal shock that precipitated, and was exacerbated by, the exchange rate crisis. These economists point out that reported fiscal budget deficits can be dwarfed by off-balance sheet exposures related to banking system losses, and thus teach us to look for fundamental shocks outside of the government’s official accounts.

Of course, there were unique contributing fundamental factors in the Mexican crisis which distinguish it from the Chilean case--the uprising in Chiapas, the assassination of a presidential candidate, the hidden sterilization of reserve outflows by the central bank, and perhaps market disappointment over the lack of commitment to a new fiscal conservatism by the newly established government deepened the crisis. But these factors do not explain why the Mexican case has so captured the imagination of economists and policy makers, who view the tequila crisis as a watershed.

What, then, was so different about the Mexican crisis, and why did its collapse usher in a new debate over global financial architecture? One answer comes from some economists who have pointed to the Mexican crisis as an example of how severely today’s active emerging market capital flows can penalize illiquidity (Sachs et al., 1997; Kehoe, 1997). In these models, small shocks to fundamentals can produce drastic declines in exchange rates if the level of short-term debt (including government treasury securities and domestic bank debt) is high relative to the amount of hard currency reserves. In such an environment, multiple equilibria may exist such that the expectation of an inability to maintain convertibility can itself cause the collapse of the exchange rate. For these economists, Mexico’s reliance on a large volume of short-term government debt (tesobonos), the rapid growth in short-term Mexican bank debt in the early 1990s, and the decline in foreign exchange reserves prior to the crisis made Mexico vulnerable to the whims of speculators, and transformed what should have been a small problem into a disaster.

That view of the novelty of the Mexican crisis may be overstated, since, as noted above, others have identified severe fundamental problems in the areas of fiscal, monetary and bank regulatory policy (Garber, 1997; Caprio and Wilson, 1998; Wilson et al., 1998). Furthermore, Garber argues that it is very difficult to disentangle empirically the relative importance of fundamentals and self-fulfilling expectations, a proposition that was first formalized by Flood and Garber (1980). Calomiris (1999) argues that the virtual absence of severe banking crises during the pre-World War I period, when emerging market capital flows were larger and more elastically supplied than today, and when exchange rates were tied to fixed gold parities, suggests that unwarranted destabilizing speculation is an unlikely explanation of current exchange rate collapses.

Perhaps the most important and uncontroversial novelty in the tequila crisis was the surprisingly large spillover effects the Mexican crisis produced in Brazil and Argentina. Brazil and Argentina saw significant contractions of debt, outflows of capital, and rises in interest rates in the wake of Mexico’s collapse. Other countries in Latin America, including Chile and Venezuela, were relatively unaffected by the crisis. In Argentina, the problems at first were confined to concerns about the maintenance of the currency board. But soon, as capital outflows produced drastic reductions in the supply of money and credit, falling incomes and rising credit risk became concerns as well. Brazil and Argentina only narrowly averted disaster in 1995.

Why should the Mexican crisis have produced concerns in Brazil and Argentina about the credibility of their exchange rates and the success of their financial liberalizations? It is not possible to explain those spillover effects by virtue of direct trade links or financial links from Mexico to Brazil and Argentina. Neither is it plausible to argue that losses to international banks and institutional investors forced the dumping of Argentine and Brazilian securities in an international scramble to shed asset risk to restore the low risk of debt for global intermediaries (this “bank capital crunch” explanation likely has more relevance for the spillover effects in Latin America from the Russian crisis of 1998). That interpretation would not explain why only Brazil and Argentina suffered large balance of payments outflows (Chile actually enjoyed inflows in the wake of the Mexican crisis). Furthermore, informal evidence suggests that much of the outflow of capital from Argentina and Brazil originated in domestic rather than foreign holdings of short-term debt.

What, then, can explain the connection between Mexican collapse and the reactions in Brazil and Argentina? One possible explanation focuses on history more than economics; the fact that the reforms in Brazil and Argentina were new and untested may have encouraged domestic residents with long memories of coinciding collapses in Mexico, Brazil, and Argentina in the 1980s to move funds out of the domestic banking systems just in case history repeated itself. In Argentina, despite the fact that its currency board was accompanied by significant banking, fiscal, and pension reforms prior to the Tequila Crisis, it still fell prey to enormous outflows, which reduced bank deposits by 20%. Apparently, even good policies, by themselves, do not ensure instant credibility. When credibility is at stake, there is no substitute for the passage of time and a track record of successfully weathering shocks.

To better understand the sources of the Mexican crisis and its spillover effects elsewhere, and to explore the lessons of the crisis for liberalization policy the Universidad Torcuato Di Tella in Buenos Aires and the Center for Latin American Economics at the Federal Reserve Bank of Dallas sponsored a conference in Buenos Aires, which was co-organized by Harvey Rosenblum and William Gruben of the Dallas Fed and Gerardo della Paolera and Juan Pablo Nicolini of the Universidad Torcuato Di Tella. Some of the papers presented there--those written specifically for the conference--are included in the set of essays collected here (for a more complete collection of conference papers, see the website of the Dallas Federal Reserve Bank, www.dallasfed.org).

The papers collected here consist of four of the academic “background” papers and five shorter papers on the policy lessons of the tequila crisis. The background papers review the fundamental economics of (1) monetary policy and its relationship to fiscal policy (in the paper by Thomas Sargent), (2) exchange rate risk (in Alan Stockman’s contribution), (3) prudential banking regulation and government safety net protection (in the paper by Charles Calomiris), and (4) the combination of financial risks present in emerging markets today, which are traceable to particular combinations of fiscal, monetary, exchange rate, and banking policies (in Frederic Mishkin’s contribution).

Following those background papers are five short presentations by prominent policy makers who discuss the relevance of these various risk factors for understanding the Tequila Crisis. Some of these were architects of economic reform in Latin America (Domingo Cavallo, Pedro Pou, Miguel Kiguel, and Humberto Capote), and one is a US observer of emerging market reforms (Robert McTeer).

Together these complementary perspectives identify the key challenges facing policy makers in emerging market economies, and some of the most effective tools for addressing the challenges of successful liberalization.

Bibliography

1. Calomiris, C.W., 1999. Victorian perspectives on the financial collapses of the 1980s and 1990s. Working paper, Columbia Business School, New York

2. Caprio, G., Klingabiel, D., 1996a. Bank insolvency: Bad luck, bad policy, or bad banking. In: Michael Bruno, Boris Pleskovic (Eds.), Annual World Bank Conference on Development Economics, 1996. The World Bank, Washington, DC

3. Caprio, G., Klingabiel, D., 1996b. Bank insolvency: Cross-country experience. World Bank Policy Research Paper 1620: The World Bank, Washington, DC

4. Caprio, G., Wilson, B., 1998. On not putting all the eggs in one basket: The role of diversification in banking. Working Paper, The World Bank, Washington, DC

5. de la Cuadra, S., Valdes, S., 1992. Myths and facts about financial liberalization in Chile: 1974-1983. In: Philip Brock (Ed.), If Texas Were Chile: A Primer on Banking Reform. ICS Press, San Francisco, pp. 11-101

6. Flood R., Garber P.M., Market fundamentals vs. price level bubbles: The first tests, Journal of Political Economy, 88, 1980, 745-770

7. Garber, P., 1997. Managing risks to financial markets from volatile capital flows: The role of prudential regulation. Working Paper, Brown University, Providence, RI

8. Kehoe, T., 1997. Modeling Mexico’s 1994-1995 debt crisis. Working Paper, University of Minnesota, Minneapolis, MN

9. Lindgren, C.-J., Garcia, G., Saal, M.I., 1996. Bank Soundness and Macroeconomic Policy. International Monetary Fund, Washington, DC

10. Sachs, J., Aaron T., Andres V., 1997. The self-fulfilling Mexican panic. Working Paper, Harvard University, Cambridge, MA

11. Wilson, B., Saunders, A., Caprio, G., 1998. Mexico’s banking crisis: devaluation and asset concentration effects. Working Paper, The World Bank, Washington, DC