Mexico is famous for tequila.
Yes, it’s famous for many others as well. But tequila is an easy recall.
And maybe that’s why we now talk about the Tequila Crisis of 1994 (it wasn’t about tequila at all).
In the 1990s, Latin American countries were starting to look tempting.
They were viewed as “emerging markets”. Among them, Mexico was a particular favourite among international investors.
It was right next to the USA. It had a large working age population.
Foreign money started entering the country.
It was really in 1988 when the newly elected president raised the level of optimism among foreign investors.
With the signing of NAFTA, Mexico was supposed to become the ‘factory of the USA’.
Mexico had a history of rebel factions fighting the government. They threatened to destabilize the “hot new emerging market” narrative.
NAFTA came into effect on Jan 1, 1994.
Confidence was high, backed by the then president’s promises.
And then a rebel uprising in the south of the country raised a few eyebrows.
“Is Mexico really as stable as we were assuming?”, thought investors.
And then, the presidential candidate was assassinated. Investors lost more confidence.
Eventually, they started selling their investments and exiting the country.
That was the gradual start of the crisis — The Tequila Crisis of 1994.
The Peso (Mexican currency) started spiralling down.
The formal name is the Mexican peso crisis.
International observers nicknamed it the “Tequila Crisis” or “Tequila Effect” because Mexico’s financial shock quickly “spilled over” into other emerging markets, especially in Latin America, much like a hangover spreading beyond the original party.
If you’re not familiar with how currency exchange rates work, the above few lines might confuse you. Let’s try to understand that in depth, and the Tequila Crisis will start making more sense.
Strengthening & Weakening
Currencies are often traded. Which means, you can buy them — like buying shares or bonds or milk.
When you visit Italy, you cannot use Indian Rupees. You have to use Euros. So you buy some euros to use in Italy (you pay for them using your Indian Rupees).
Once your trip is done, you return to India, where Euros are not accepted. So you need to convert the Euros you have back to Indian Rupees.
So you use your Euros to buy Indian Rupees (you pay in Euros to buy Rupees).
The moment buying and selling is involved, there’s supply and demand.
And we know all too well that supply and demand can increase or reduce the price of a commodity.
When too many people are trying to buy Euros (by selling their Indian Rupees):
+demand for Euros is up
+therefore supply of Rupees is also up
The obvious happens. The price of Euros goes up. The price of Rupees falls down.
If earlier you had to pay Rs 120 to get €1, now you might have to pay Rs 125 to get €1 (example).
So we will say ʼthe Euro strengthened and the Indian Rupees weakenedʼ.
This is called the exchange rate — the amount of one currency needed to buy another currency.
The above was an example of the Euro-Indian Rupee exchange rate.
At any point, millions and billions of currencies are being bought and sold. This keeps the net price at a similar level.
When trades lean one way more or the other, the exchange rates increase/decrease accordingly.
BoP
So what’s the problem? What happens if the exchange rate goes too high or too low?
A lot can happen. It can be good. It can also be bad. People worry mostly about the bad parts (of course).
If a country imports food products, a falling exchange rate can mean more expensive food. Very worrying — not good.
Similarly, if it imports critical items and relies on them heavily, it will hurt the country’s economy and people.
The opposite does not automatically mean good.
For exporting nations, a strong currency is not good.
Many countries have factories that are appealing to richer countries because factory-worker salaries are cheap. If the country’s currency strengthens, those salaries automatically go up.
It could mean that fewer orders come to those countries, resulting in loss of trade and jobs.
Countries that rely heavily on exporting actually intentionally weaken their currency too.
By now you would be able to guess the positives here.
A strengthening currency is good if you’re importing. A weakening currency is good if you’re exporting.
In fact, it isn’t just about imports and exports. Money enters and leaves a country due to several other factors.
Some of those factors are:
+Import & export of goods (already discussed)
+Import & export of services
+Remittances (people working in foreign countries sending money home)
+Foreign Direct Investment
+Portfolio investment (investing in stock markets, bonds, etc)
+Borrowing and repayment of loans (companies taking loans from foreign lenders)
+Sending back profits to home country (foreign companies do this)
+And a few others
Each of these causes money to flow in and out of a country. And therefore, each of these affects the exchange rate of a country.
This is called Balance of Payments (BoP).
The balance is between payments coming in and leaving from the country.
Mexico
Back to Mexico.
The Tequila Crisis was a Balance of Payment Crisis.
The Mexican peso exchange rate with the US dollar was kept stable thanks mostly due to incoming investments.
So when investors started pulling out, the exchange rate started crashing. That made it difficult for them to import essential items which only worsened the situation.
Actually, initially, the Mexican central bank was able to control the exchange rate fall. How?
Central banks can control the exchange rate to some extent. They do so by maintaining reserves of foreign currencies.
When demand for the peso fell, Mexico’s central bank sold dollars from its reserves and bought pesos. This created demand for pesos and helped slow the fall.
Since the supply of the foreign currency goes up because of this, it can offset the effect of the increased supply of the local currency.
But it can only work for some time. The reserves eventually run low and the central bank can’t do much after that.
The crisis left a deep scar in Mexico’s economy. But they did bounce back from it after reforms and some loans being extended.
There have been many famous big BoP crises.
+Asian Financial Crisis of 1997
+Black Wednesday (UK) of 1992
+BoP Crisis India in 1991
+Argentina in 2001-2002
+Russia in 1998
It’s an interesting list. Each of them makes for an interesting read.
Quick Takes
+ India has launched E85 fuel, an 80-85% ethanol blend designed specifically for flex-fuel vehicles, across 48 retail outlets. It is priced around Rs 20 less than normal petrol (per litre). A flex-fuel vehicle is a vehicle equipped with an engine that can run on petrol, ethanol, or any blend of the two.
+ India’s current account surplus narrowed to $7.1 billion (0.7% of GDP) in the Jan-March quarter (vs $13.7 billion or 1.4% of GDP in the same quarter last year).
+ Zepto has filed an updated DRHP (Draft Red Herring Prospectus) for a Rs 8,010 crore IPO.
+ Fresh military strikes have taken place between the US and Iran, disrupting talks for a peace deal.
+ The government has approved Phase 2(A) of the Ahmedabad Metro Rail Project at a cost of Rs 2,169 crore.
+ CMR Green Technologies IPO listed on the stock exchanges at a premium of 39.58% over the issue price and closed 25.62% up at the end of the day.
+ The government has extended its zero-tax (no excise duty) exemption on petrol blended with higher levels of ethanol from E22 up to E30.
+ India’s annual inflation rate rose to 3.93% in May (vs 3.48% in April).
+ India’s forex reserves fell by $0.71 billion to $681.61 billion in the week that ended on 5 June.
+ The government has banned industrial and commercial users from buying bulk petrol and diesel at retail petrol pumps. Retail diesel purchases are now capped at 200 liters per vehicle daily for the next 90 days.
The information contained in this Groww Digest is purely for knowledge. This Groww Digest does not contain any recommendations or advice.
Team Groww Digest