In December 1994, Mexico faced a balance-of-payments crisis. Investors lost confidence in Mexico's ability to maintain the exchange rate of the peso within its trading band. Intense pressure on the peso in foreign-exchange markets threatened to exhaust Mexico's international reserves.
On December 20, the Mexican government announced its decision to devalue the peso against the dollar by 14 percent. This decision, however, touched off a panic situation to sell pesos. As a result, on December 22, the peso fell against the dollar by as much as 40 percent, compelling the Mexican government to float the peso. A rash of speculative attacks against other Latin American currencies — Argentina (peso), Brazil (real), Peru (new sol), and Venezuela (bolivar) — broke out immediately through what became known as the "tequila" effect. Several countries that are not part of Latin America - Thailand, Hong Kong, the Philippines, and Hungary - also suffered brief speculative attacks. However, only few countries actually devalued their currencies. Argentina was the only other country that suffered a sharp recession as a result of the Mexican peso crisis.
On January 31, 1995, the IMF and the US government put together a $50 billion package to bail out Mexico. We discuss this peso crisis in detail through two mini-cases: one at the end of this chapter and another at the end of chapter 9.
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