The tequila effect

The tequila effect

The disruption of Mexico's economy in late 1994 triggered a confidence crisis in Argentina's financial system in early 1995. Despite the considerable progress made since 1991 instrengthening Argentina's banking system, the Mexican crisis took its toll. In late 1994, market sentiment about the Argentine financial system was distinctly more bearish owing to slower growth ofdeposits, rising world interest rates, reduced capital inflows, and declines in the prices of Argentine government bonds as well as stocks. In November 1994, financial markets became jittery followingthe failure of a small nonbank trader caused by losses in government bond trading. The failure caused most banks to cut their credit lines to other bond traders, thus further weakening a bear market.This, in turn, eroded the financial position of several banks with large government bond inventory and trading positions.

The devaluation of the Mexican peso on December 20, 1994, and the resultingcapital outflows throughout Latin America triggered the crisis. The wholesale banks were among the first to feel its effects. Typically, these banks (about 30) had large stock and bond tradingpositions and one branch, and depended almost entirely on large corporate deposits. Withdrawals from these banks and simultaneous cuts in interbank lending forced some of the wholesale banks intoliquidation. As news of the failures spread, and in the absence of deposit insurance, retail depositors fled from weak provincial, cooperative, and small retail banks, thus producing a major banking crisis.While some of the funds were redeposited in the largest private and foreign banks, there was a net deposit withdrawal of $8 billion from the banking system, equivalent to 16 percent of the deposit base.The policy response. Argentina's Convertibility Law requires the monetary base to be limited to the level of foreign exchange reserves (with some limited flexibility), severely restricting the...