The financial and economic negative effect on South American equity markets and currencies that was triggered by the Mexican peso devaluation in 1994. The collapse of the Mexican peso immediately crossed the southern border and badly hit stock markets and foreign exchange markets throughout the region, mainly Latin America. This effect was induced by two types of factors. First, as perceived risks rose and expected returns dropped, individual investors rushed to divest. Second, institutional investors, such as mutual funds, faced with actual or potential redemptions, sold their holdings not only of Mexican investments but also of investments in other emerging economies. That spread financial contagion across Latin America, though with a stronger impact on Argentina and to a lesser extent on Brazil, where domestic recessions and dramatic equity market declines in these countries ensued. Actually, Argentina was the principal victim of the “tequila effect,” losing more than a third of its currency reserves in the three months following the peso crisis.

Economic contagion, high and volatile interest rates, an abrupt drying up of foreign lending and investment flows, and banking weaknesses dramatically contributed to decreasing share prices and hindered new equity offerings in 1995. The capitalization of Mexico’s market fell 35 percent in 1994, reflecting the dramatic year-end decline in values, and another 30 percent in 1995. The Argentine market was hit less dramatically, with a 16 percent drop in market capitalization in 1995. Chile was spared the worst of the Tequila effect that followed the Mexican crisis thanks to its system of capital controls.

Argentine and Brazil were viewed as having the same common flaws that Mexico endured; namely:

1. Low savings rates.
2. Significant current account deficits.
3. Weak banking systems.
4. Large volumes of short-term debt.

The tequila effect is also known as Mexican shock.