Financial Crises in Emerging Markets: The Lessons from 1995

The Mexican peso crisis of December 1994, and its reverberations in the financial markets of developing countries around the world, has intensified the debate over the nature of balance of payments crises in developing countries. Many simple explanations have been given for the crisis and its aftermath, but none of them does very well at accounting for the main patterns of behavior in emerging markets during late 1994 and 1995. The financial events following the devaluation of the Mexican peso are examined to uncover new lessons about the nature of financial crises. A simple model is presented that identifies three factors that determine whether a country is vulnerable to financial crisis: a large appreciation or the real exchange rate, a weak banking system, and low levels of foreign exchange reserves. Many of the alternative hypotheses that have been put forth to explain such crises are not supported by the data. While there were many reasons for a devaluation of the Mexican peso at that time, the speculative attack and the magnitude of the resulting currency depreciation went far beyond what was inevitable based on Mexico's fundamental conditions.