DECEMBER ERROR: BACKGROUND, CAUSES AND CONSEQUENCES - HISTORY - 2025

The "December error" or Tequila Effect was an economic crisis that began in Mexico in 1994 and lasted until the end of 1995. It is the worst Mexican economic crisis and had serious repercussions in the world. It happened at the beginning of the presidential term of Ernesto Zedillo due to the drastic decrease in international reserves.

This crisis caused the maximum devaluation of the Mexican peso and generated alarms in international markets due to the impossibility of Mexico to fulfill its international payment commitments. The phrase "December error" was pronounced by former President Carlos Salinas de Gortari to exempt himself from blame for the crisis.

Ernesto Zedillo and Carlos Salinas de Gortari during the inauguration ceremony

Salinas had just finished his six-year presidential term, precisely in December 1994, when it exploded. He wanted to attribute to the incoming government of Ernesto Zedillo all the causes of the crisis, exonerating himself of the errors of economic policy committed in his administration.

It is also called the Tequila Effect due to the repercussions that this financial crisis had inside and outside of Mexico. Entrepreneurs, industrialists, merchants, bankers and workers were the first to feel its impact. There was a wave of layoffs and even suicides, due to the tension generated by debts with foreign suppliers.

The followers of Salinas de Gortari and critics of Zedillo argued that it was a political and economic error by the administration of the incoming government, specifically the announcement of the devaluation of the Mexican peso in the terms in which the new government made them. However, they recognized that decision as necessary and correct.

Background

Since 1981, Mexico had been dragging a severe economic crisis due to the drastic fall in oil prices in the international market, but the impact of the weakening of oil prices in the Mexican economy was felt more strongly than in other exporting countries.

This was so because, in addition to the drop in oil revenues, the rise in interest rates on the Mexican foreign debt was added. This meant a large net transfer of resources abroad that ended up weakening the precarious economy.

On the other hand, foreign investment in the country fell to historical levels, making the crisis even worse.

By that time, Mexico had already increased its non-oil exports progressively, especially agricultural and textile exports with the maquilas. Thus, the contraction in economic activity between 1986 and 1987 was not exclusively due to the crisis in the oil market.

There were other elements that weighed even more in its gestation. However, the main cause of the crisis of the 1980s was the increase in interest rates that occurred in 1985 in the United States. This increase had a decisive effect on the economy, as the disbursements that Mexico had to make increased.

Chronic indebtedness

Historically, Mexico has been a country with a chronically indebted economy; This phenomenon has been present since the time of Independence.

Upon assuming power, each government has separately incurred in the growth of the voluminous external debt, in cycles of indebtedness and capital outflows that always leave the economy with red balances.

These debt cycles are opened during changes of government. The heavy Mexican foreign debt, instead of gradually decreasing, increased in the 70s, 80s and 90s of the last century.

In particular, these increases in debt occurred during 1975 (with an increase of 55%) and later in 1981 (47%).

Later it increased in 1987 (6%) and in 1993, year in which the level of indebtedness was 12%. Debt increases have occurred before or immediately after the new government took office. For the 1994–1995 biennium, indebtedness was 24% and 18%, respectively.

As can be seen, the indebtedness pattern is high at the beginning, then decreases in the middle of the period and picks up at the end or at the beginning of the next administration.

Increased payments and capital outflow

From the 1980s to 1992, foreign debt payments ranged from $ 10 to $ 20 billion. However, at the end of the 1990s, these payments increased from $ 20 billion to $ 36 billion.

Capital outflows from Mexico are also associated with changes of government, except in 1985. That year the capital flight was due to the oil price crisis and the 1985 earthquake in Mexico City, which severely hit the economy.

For example, in 1976 capital outflow was $ 1 billion, and from then on it increased to $ 7 billion in 1988. Then it went up even more, until it reached the dramatic levels of 1994.

Economic adjustment plan

In addition, the economic adjustments that were applied, since 1985 tried to reduce public spending to balance the national accounts. On the other hand, they sought to reduce inflation and diversify the economy to overcome dependence on oil.

As a result of oil income, that year US $ 8.5 billion entered the country, representing barely 6.6% of GDP, an insignificant figure compared to the size of the economy, state expenditures and net exports of capital abroad.

Faced with financial difficulties, the federal government had to apply a much more restrictive fiscal policy and severely cut spending.

Banking privatization and lack of regulation

During the government of Carlos Salinas de Gortari (1988-1994) there was significant economic growth. Many state-owned and mixed-capital companies were also privatized, under non-transparent conditions.

Among the privatized companies, the banks stood out. The financial system did not have an adequate regulatory framework at that time, and the new bankers did not have enough financial experience to run the business. The result was the banking crisis of 1995.

Causes

Capital flight

The massive outflow of capital in 1994 reached the astronomical figure of 18 billion dollars. This currency run is the largest and most impressive that has been recorded in the economic history of Mexico in such a short time.

Between 1970 and 1998, international reserves fell at a more bearable rate, as was the case in the years 1976, 1982, 1985 and 1988.

However, in 1994 the fall in international reserves was so great that the United States was forced to intervene, because most of the Mexican creditors were American banks.

The president of the United States, Bill Clinton, asked the Congress of his country to authorize a line of credit to the Mexican government for 20 billion dollars, so that Mexico could meet its international financial obligations.

Devaluation of the Mexican peso

The other cause of the crisis was the devaluation of the Mexican peso, which caused the fall of Mexican international reserves. This occurred just beginning the presidency of Ernesto Zedillo, who took office on December 1, 1994.

During a meeting with national and foreign businessmen, Zedillo commented on his economic policy plans, among which was the devaluation of the peso.

He announced that he planned to increase the exchange rate band by 15% to bring it to 4 pesos per dollar. At that time, the fixed exchange rate was 3.4 pesos per dollar.

He also commented that he wanted to end unorthodox economic practices, among which were the purchase of debt to take advantage of the country's situation. In this way he thought to stop the outflow of dollars from the economy and the fall in international reserves.

The outgoing government of Carlos Salinas de Gortari accused the Zedillo government of leaking privileged information to important Mexican businessmen. Faced with such an eventuality, the peso immediately suffered a resounding fall.

According to Salinas de Gortari, in just two days (December 20 and 21, 1994) 4,633 million dollars of international reserves left Mexico. By January 2, 1995, the country's financial coffers were completely emptied, leaving the nation without liquidity.

Recklessness

It is recognized that there was recklessness on the part of the government of Ernesto Zedillo in the treatment of the economic policy that it planned to adopt, beginning by revealing the economic plans previously and then announcing the devaluation, which caused havoc in the public coffers.

The Tequila Effect had more time to act quickly, in the midst of a situation that caught the government off guard, which did not know how to react in time.

Permanent deficit

The Ernesto Zedillo government counterattacked and accused Salinas de Gortari of having left the country's economy prostrate by causing serious distortions.

According to Zedillo, one of the reasons for the crisis was the growing deficit produced by the current account of the balance of payments, which was financed with highly volatile or “swallow” capital.

Debt and bad policies

There was financing of long-term projects with short-term debt instruments, as well as the reckless appreciation of the real exchange rate. There were public debt liabilities maturing weekly, which generated a permanent disbursement of resources.

Another reason was the late reaction to attack the causes of the crisis. The dollarization of domestic debt (for example, tesobonos) also played a role, causing it to grow exponentially as interest rates in the United States increased.

Increase in interest rates

The rise in interest rates by the Federal Reserve of the United States, with Alan Greenspan at the helm, upset the macroeconomic balances of Mexico and most of the countries in the world.

The imbalances generated by this US policy were felt more strongly in Mexico due to the colossal indebtedness it had at that time.

Low internal savings

Another element that influenced and aggravated the Mexican economic crisis of 94-95 was the lack of domestic savings.

Mexico completely neglected this aspect. Of the 22% of GDP (Gross Domestic Product) that Mexicans saved on average in 1988, for 1994 savings stood at just 16%.

Consequences

Economical

- The consequences of the "December error" or Tequila Effect did not wait. The price of the dollar immediately increased to about 300%. This caused the bankruptcy of thousands of companies and the inability to pay the debts on the part of the debtors.

- As a consequence of the massive bankruptcy of companies (banks, businesses, industries), unemployment rose to unbearable levels, which generated a serious social crisis.

- The economy went into recession, the peso was devalued above 100 percent and international reserves were almost zero.

- Faced with the impossibility of being able to maintain the new band established for the exchange rate, at the beginning of 1995 the government established the free floating system of the peso. In just one week the dollar was priced at 7.20 pesos.

- Previously announcing the devaluation to investors and establishing a floating exchange rate was what Salinas de Gortari called the "December error."

- The Gross Domestic Product (GDP) had a drop of 6.2 percent.

- There was a total loss of credibility and confidence in the financial system and in the government's economic plans. State finances were devastated.

- The capitals that fled from Mexico and Latin America due to the Tequila Effect went to Southeast Asia.

Social

The social effects in Mexico caused by the "December error" were incalculable from an economic and psychological point of view for millions of families. The loss of their homes, cars, businesses, savings, assets, and other properties completely ruined much of the nation.

There were people who lost everything, being left in the most absolute misery and without immediate possibility of being able to face the dramatic situation. A deep sense of frustration and loss of hope for the future gripped the country.

The middle class was the hardest hit by the crisis and it was considered to be the end of it, since it would take a long time to recover from the great losses.

The poverty levels of the Mexican population rose to 50%. Although thousands of families managed to escape poverty in the decades that followed, the impact of the crisis has endured to the present.

End of crisis

The peso crisis could be averted through an aid package granted by the United States as Mexico's trading partner. The aid began with the purchase of Mexican pesos by the US to curb the devaluation.

The banking system was cleaned up through an economic adjustment plan, implemented through the Currency Stabilization Fund.

In addition to the 20 billion contributed by the United States, a loan for a similar amount was granted by the International Monetary Fund. In total, the financial aid was $ 75 billion.

At the end of 1995, the Mexican crisis could be controlled, but the GDP continued to contract. Inflation reached 50% annually and other companies were closed. A year later the economy managed to grow again and Mexico was able to pay the loans to the United States.

References

1. Tequila effect. Retrieved on June 7, 2018 from laeconomia.com.mx
2. 1994-1995 Mexico crisis. Consulted of auladeeconomia.com
3. The December bug. Consulted of planoinformativo.com
4. 6 graphs to understand causes and effects of the 'December error'. Consulted of elfinanciero.com.mx
5. The "December error", the beginning of a great crisis. Consulted of moneyenimagen.com
6. Limits and potential of the Mexican economy at the end of the 20th century. Consulted of mty.itesm.mx.
7. Tequila effect: Mexican economic crisis of 1994. Consulted of monografias.com