The peso quickly lost value in 1994.
A currency crisis occurs as a nation's currency suddenly and rapidly devalues. While there are numerous factors that lead to a currency crisis, the immediate cause is a flight of capital from the country in response to perceived instability on the part of foreign investors. This resulting devaluation means that one unit of currency is not worth as much as it previously was, which leads to rapid inflation. In the case of Mexico's 1994 peso crisis, the root causes that led investors to quickly pull out were political mismanagement, unfavorable macroeconomic conditions and regional instability.
Political Instability
In the lead-up to the 1994 crisis, the economic outlook for Mexico was excellent. The country had recently been admitted to NAFTA and had consequently lowered a number of barriers to investment and trade. Nevertheless, in 1994 a candidate for the ruling Institutional Revolutionary Party (PRI), Donaldo Colosio, was assassinated. Meanwhile a Zapatista uprising in the Chiapas region, the kidnapping of numerous executives and another assassination of a PRI leader heightened the political tension. This instability made investors wary and contributed to a rapid flight of assets as the crisis emerged.
Over-Expansive Monetary Policy
The economic success of Mexico leading up to 1994 meant that there was an overwhelming inflow of foreign capital and a high current account deficit. Although inflowing foreign capital is generally a good thing, most of this was portfolio investment in stocks, bonds and mutual funds. This type of investment is particularly easy to withdraw. When this capital inflow slowed, there was pressure for the peso to devalue, but the government fought this by buying foreign capital directly and extending credit to the banking industry to keep interest rates low. This was an unsustainable arrangement.
Fixed Exchange Rate
The Mexican government had a fixed exchange rate system, and paid out dollars for pesos as investors removed their assets. Despite the large foreign exchange reserves of the Mexican government prior to 1994 it could not continue to pay out dollars by the end of 1994. Therefore, the government had to allow devaluation of the peso at a certain point, which spooked investors and triggered a run on the currency (a vicious cycle in which investors rush to convert their assets before the currency declines further).
Straining of national finances
Leading up to the 1994 national election, the PRI dramatically increased spending on a variety of popular projects as a way of generating support. The relatively high budget deficit that year further raised the risk profile of Mexico leading up to the crisis and contributed to the flight of foreign capital.
Current Situation
Following the 1994 crisis the Mexican government opted to let the peso float. The result was a necessary devaluation of the peso from four to the U.S. dollar to around seven. Fearing a prolonged economic slump, the United States Treasury intervened, providing loan guarantees of $50 billion and buying up pesos on the open market. These measures were successful and the peso stabilized at a ratio of six to a U.S. dollar. Throughout the late 1990s strong economic growth resumed in Mexico and the floating peso remained at about this level. Since then the peso's fluctuations have been in response to real-time valuation of the currency by investors as opposed to the fixed-peg system in which the government heavily intervened. Since the mid 2000s it has sat at about 10 to a U.S. dollar, though this fluctuates.
