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Liberalization and Foreign Policy, by Miles Kahler, editor
Financial Liberalization and Regional Monetary Cooperation: The Mexican Case
Sylvia Maxfield
Economic liberalization can be self-reinforcing and/or destabilizing. Few cases highlight this more clearly than the case of Mexican finance, where, in the space of a few years, problems related to Mexico's international capital account led to both populist backlash and rapid liberalization. In 1982 the country's banks were nationalized and foreign currency exchange was severely circumscribed. By 1985 the country was pursuing financial sector liberalization faster than the World Bank thought wise. By 1992 the commitment to financial liberalism had become linked to plans for "binding" institutional change: greater central bank independence and possibly formal bilateral or multilateral monetary policy coordination.
This essay looks at one instance of Mexican financial liberalization: commitment to a more market-guided foreign exchange policy in 1991. With the benefit of hindsight one can see that this shift from a fixed rate to a band did not prevent dramatic and sudden devaluation in 1994. But in the aftermath of that crisis, Mexico is once again moving away from a fixed government-set rate toward a market-driven band. The following discussion explores how and why the shift from a fixed to a more flexible exchange rate regime might be related to the likelihood of Mexican commitment to institutionalize North American monetary cooperation. It is a speculative exercise designed to complement this volume's overall focus on the connection between liberalization and foreign policy.
Plausible explanations of the causal logic behind stabilizing or destabilizing liberalization in this case could center on the impact of internationalization on sectoral interests and policy preferences, or on government concerns with enhancing credibility, independent of sectoral interests. The central analytical point of this essay is that the dichotomy frequently associated with these two types of explanations is false. The credibility imperative is cited to explain many recent Mexican economic policy initiatives ranging from the Economic Solidarity Pact to the North American Free Trade Agreement. 1 It is, however, difficult--if not impossible--to understand when and why credibility becomes a priority without understanding the actual and historical impact of the "structural power of capital." 2 In concrete terms, analysis of the structural power of capital leads us to observe the preferences and actions of groups of entrepreneurs or wealthy individuals. The larger the percentage of entrepreneurs or wealthy individuals with global investment options, the greater the likelihood that a poor policy environment will contribute to a lack of national credit and investment. The more global investment options, the greater entrepreneurial demand for credible national policies that preserve the ability to operate globally. The greater the international competition for capital among different national governments, the more important government credibility is. Purveyors of investment or credit will require especially strong credibility-enhancing efforts of any government with a history of broken policy promises.
Although many strictly political factors, such as the nature of the rules of electoral competition, shape the weight and extent of a government credibility deficit, the economically driven aspects of credibility constitute a necessary part of the explanation. In the Mexican case surveyed here, growing economic integration put the issue of credibility on the agenda. Integration increased the potential costs of a credibility deficit and the potential benefits of a credibility surplus. The more globally integrated the Mexican economy, the greater the loss of potential investment or credit correspondent to low credibility, and vice versa. In Mexico, a history of liberal policy regarding currency convertibility in combination with cycles of inflation and currency overvaluation had created distrust of government commitment to a fixed exchange rate. A desire to solve this credibility problem shaped the Mexicans' choice of a more flexible foreign exchange regime, which some hoped would eventually be backed by a bilateral or multilateral agreement on monetary and exchange rate policy.
Loosening the reins of government control over the level of the peso-dollar exchange rate has increased the credibility of the Mexican government's commitment to liberalization and monetary stability, as was explicitly intended. But proponents of this policy are keenly aware that both increased central bank independence and formal bilateral or multilateral monetary policy agreement would provide key signals of the likelihood of Mexican politicians' future behavior when confronted with conflict between short-term political interests and policy commitment.
This analysis of financial liberalization and foreign monetary policy in Mexico suggests that, to the extent that financial liberalization increases international integration, liberalization is likely to lead to monetary cooperation in the medium to long term. This is because of integration's impact on the size and preferences of the group of entrepreneurs/wealthy individuals with international investment options, and on this group's ability to shape the priority that government actors assign to credibility enhancement. Economic integration increases capital's exit options. To the extent that nations and their political leaders need credit and investment, integration increases politicians' vulnerability to the perceptions of credibility deficit held by purveyors of credit and investment. The greater capital's exit options, the more important the credibility of government commitment to policies intended to create a felicitous national environment for capital. Commitment to foreign monetary policy can be credibility-enhancing. Thus financial liberalization is likely to contribute to a stable cooperative pattern in foreign monetary policy by leading politicians to prioritize the credibility of government commitments to policies desired by internationally mobile capital.
Although this logic is motivated by the impact of changing international opportunities on the preferences of capitalists and on their power to influence politicians, institutional change, whether in domestic institutions or in a country's participation in international arrangements, is a component of stabilizing liberalization in several ways. It is a powerful signal of politicians' independent commitment to credibility-building as well as an indication of future constraints on possibly less-self-disciplined politicians. It is also clear that domestic institutional change and international commitment are mutually reinforcing; each lends force to the other, with causal influence running in both directions simultaneously.
Origins of a Credibility Problem: Free Convertibility and Fixed Exchange Rates
Mexico has had a long-standing commitment to free exchange convertibility combined with a unilateral dollar peg of the exchange rate. This historical commitment to international financial liberalism in the sense of freedom to convert currency has not been matched, until recently, in other areas of international financial transaction. 3 The combination of free convertibility and a unilateral, but unsustainable, peg and other restrictions on capital mobility has created cycles of external shocks and domestic policy errors leading to creeping peso appreciation, speculative attack on the currency, recession-inducing devaluation, and occasionally a nationalistic policy backlash such as occurred at the end of the Cárdenas, Echeverría, and López Portillo administrations. 4 Commitment to a fixed exchange rate itself is a function of the nationalistic symbolism popularly imbued in the dollar-purchasing power of the peso.
This history of exchange instability contributed significantly to the credibility problem that is an important part of the context of further liberalization moves in the 1990s. Dollarization, use of the U.S. dollar rather than the peso for the major purposes usually served by money, and destabilizing capital flows have been a constant threat to the Mexican financial system at least since the beginning of the Mexican revolution in 1910. In the aftermath of political and economic upheaval, the exchange rate did not stabilize until the 1930s. After two years of floating peso exchange rates, in 1933 Mexican president Cárdenas fixed the peso's value at 3.6 to the dollar, where it remained until a speculative crisis in the wake of the Mexican government's 1938 nationalization of the oil industry forced a devaluation. 5 At that time Cárdenas considered and rejected the option of exchange controls, on the grounds that they would be impossible to implement, given the long U.S.-Mexican border, and that the governments' administrative capacity was too limited. After a short period of managed floating, the peso was returned to a fixed exchange regime, disrupted only by speculation-forced devaluations in 1949 and 1953.
In 1955 Mexico entered an exceptional period of exchange rate stability; the peso remained at the same fixed rate, 12.5 to the dollar, until 1976. Some observers believe the peso had become unsustainably overvalued by as early as the late 1960s. In any case, inflation accelerated extremely rapidly in Mexico during the early and mid-1970s, with rates far above those in the United States. Although Mexican president Echeverría had sworn he would "defend the peso like a dog," the accumulated overvaluation led to speculation and capital flight, finally forcing devaluation in 1976.
After this adjustment, the Mexican government returned again to a fixed exchange rate regime. 6 Discovery and pumping of vast oil reserves in Mexico, combined with excess liquidity in the international banking system, led to a huge inflow of foreign exchange. This foreign exchange bonanza put upward pressure on the peso again, leading to an even more severe speculative attack and massive capital flight in 1982. Speculation intensified after the central bank withdrew from the exchange markets and allowed the peso to float freely in February 1982. In August 1982 the government announced a dual exchange rate system composed of a free market rate and a preferential, central bank-managed rate for specified priority imports.
This cycle of overvaluation fueled by inflows of foreign exchange from borrowing and oil exports, speculation against the peso, capital flight, and devaluation culminated in September 1982 in the sudden nationalization of domestic banks and imposition of exchange controls for the first time in postrevolutionary Mexican history. The free market exchange rate was eliminated as part of the implementation of comprehensive exchange controls. The government restricted transfer of funds outside of Mexico, even tightly limiting the amount of foreign exchange that could be acquired for international travel. Proceeds from exports had to be repatriated and sold immediately to the banks, while dollars for imports were rationed. 7
The September 1 financial policy backlash reflected the temporary hegemony of heterodox economists in government and their constituency of labor and small-to-medium-size industrialists over neoliberal economists and their constituency of large-scale capitalists. The conflict between these two coalitions was termed "the fight for the nation" (la disputa por la nacion) by Carlos Tello, architect of the bank nationalization. 8 This long-standing dispute in Mexican politics had been heightened by the boom in international financial markets and its differential impact within Mexico in the late 1970s. Benefits of the boom flowed disproportionately to large-scale Mexican entrepreneurs. The international integration of Mexican financial markets created new opportunities for large-scale capitalists and fueled financial speculation. This in turn provided a material basis for popular-sector resentment of the bankers' windfall and for the belief of "left-wing" government economists that liberal capital regulation was undermining the state's capacity to induce and guide capital formation in the name of equitable growth. These economists argued that bank nationalization would allow the government to regain lost control over the national financial system and harness the financial sector to the goal of economic restructuring. Furthermore, easy access to foreign loans during the debt boom of the 1970s and early 1980s undermined the leverage of the Mexican finance ministry and central bank to oppose proponents of bank nationalization.
International funds dried up with Mexico's dramatic policy shift, and in a new atmosphere of international capital scarcity, purveyors of foreign exchange found themselves once again able to guide financial policy generally. Exchange controls began to be removed in December 1982, and plans for bank reprivatization were made. A new three-tier exchange rate system was introduced, composed of a preferential rate, a less preferential "controlled" rate, and a free rate. In the following years the preferential rate and the controlled rate were collapsed into a single rate. In 1986 the Mexican government began to try to bring the controlled and free rates into closer alignment by minimizing official support for the controlled rate. In 1987 the government moved back to a fixed rate system; after a large devaluation, the peso-dollar exchange rate was fixed for almost a year. Between 1989 and 1991 there was a single exchange rate subject to a minimal, pre-announced, and constant daily devaluation vis-á-vis the dollar.
In the context of a fixed rate system with free convertibility it is not surprising that an externally vulnerable economy and a political mythology that made devaluation virtually taboo left Mexico vulnerable to speculative attacks on the peso. Speculation about devaluation was also entirely reasonable given long-run trends in the real value of the peso. McLeod and Welch show that when the real peso value appreciated, it tended historically to return to the mean level within three to four years. 9 The message that peso appreciation sent to investors was to expect partial reversal within several years. Despite Mexico's comparatively liberal policy on exchange convertibility, exchange rate instability and the nationalistic policy backlashes that it sometimes engendered limited the hope for economic liberalization and, with it, long-term fixed investment in Mexico both by nationals and foreigners.
The Mexican central bank, the Banco de Mexico, finally broke with the directly government-controlled exchange rate regime in late 1991. Although it was denied publicly, in 1991 U.S. and Mexican central bank officials began probing the possibility of a monetary agreement involving a bilaterally negotiated currency band, or target zone, within which the peso's value would be set by exchange market conditions. At its outer limits the band would be backed by currency swap or reserve-sharing agreements and occasional summits like those among the G-7 countries between the nation's central banks. 10 When support for this idea seemed to wane within the U.S. Federal Reserve system, discussion took place within the Mexican central bank over the idea of linking Mexican concessions on opening the financial sector in free trade negotiations to achievement of a multilateral exchange rate agreement including emergency credits for maintaining parity. 11 But in November 1991, the Banco de Mexico unilaterally liberalized control of exchange rate movements, allowing the market to price the peso within a target zone. The change in policy was discussed publicly only beginning in April 1992, when the band was further widened.
This liberalization of exchange rate policy has provided for the growth of a futures exchange market, a development that has reduced the destabilizing impact of capital flows on the exchange rate and thereby reduced the likelihood of nationalistic backlashes against international liberalization and integration. 12 Mexican central bank officials remain interested in the idea of a formal international monetary agreement to back the target zone.
The history of exchange instability and its detrimental impact on investment and growth, related to Mexico's historical commitment to one aspect of international financial openness--free exchange convertibility--is an important part of the general context in which this further exchange policy liberalization and monetary cooperation initiative occurred. Yet many questions remain. What explains the particular timing of this decision? Why was instability addressed with a unilateral commitment to a target zone rather than with controls on convertibility?
Negotiation of the North American Free Trade Agreement led naturally to some comparison with the Single Europe Act and the Maastricht Treaty. 13 At a fall 1991 meeting, "Policy Implications of Trade and Currency Zones," sponsored by the Federal Reserve Bank of Kansas City, Mexican central bank director Miguel Mancera was forceful in denying any similarity between North American and European integration and in negating the possibility of a move toward monetary coordination between the United States and Mexico. "I would say [the same]," responded former U.S. Federal Reserve Bank board chairman Paul Volcker, another participant in the meeting. "It may be politically suicidal and economically premature to say anything else. But I also have a feeling," continued Volcker unabashed, "that they doth protest too much." 14
Those arguing against the parallels between the European and North American situations and against the likelihood of U.S.-Mexican monetary coordination stressed the political motive behind European monetary coordination, arguing that no such political rationale exists in the North American case. 15 Nevertheless, there is an economic argument for European monetary coordination that is potentially valid in the U.S.-Mexican case also. Support for monetary coordination within the context of European integration did not develop until the late 1960s, after the initial stage of the trade union was under way. By the end of 1969, however, two years of monetary crises and the consequent exchange rate instability had made it clear to leading European officials that lack of monetary coordination and the resulting potential for exchange rate instability posed a threat to the customs union. 16
The overarching purpose behind the North American Free Trade Agreement was to increase capital inflows into Mexico. 17 Exchange instability could threaten both the agreement and the capital inflows that it was meant to induce. 18 During NAFTA negotiations, despite the threat to exchange rate stability, the Mexican government kept the peso slide slow in order to help stabilize inflation and raise foreign purchasing power to facilitate import of inputs necessary for expansion of nontraditional exports. There were several dangers in this situation. The current account deficit resulting from exchange rate-facilitated foreign purchasing threatened to become unsustainable. The peso's real appreciation also posed a menace to Mexican export competitiveness. The administration of President Salinas hoped that the growth and productivity boost expected from the U.S.-Mexican trade agreement would allow the Mexican economy to catch up with its overvalued exchange rate before the threat of speculation against the peso rose. Another danger stemmed from the potential animus to the Free Trade Agreement that a sudden devaluation, making Mexican exports more competitive, could create in the United States.
The U.S. Federal Reserve was sufficiently convinced of the importance of monetary aspects of North American economic integration that it increased the dedication of its research personnel to Mexico-watching, and in particular to consideration of Mexican exchange rate policy. Federal Reserve economists advocated change in the Mexican exchange rate regime to protect the promise of U.S.-Mexican trade and Mexican growth in general. Congressional representatives in the United States also began to call for a fourth supplemental agreement to the North American Free Trade Agreement, one that provided for exchange rate stability. 19
The Mexican central bank sent a study mission to Europe to gather information on European exchange policies and monetary integration. The goal was to formulate a report, based on European experiences, about the likely impact on Mexico of possible regional monetary integration. After carefully studying the Spanish case in particular, Mexican central bankers came to believe that a bilateral target zone might create conditions for another long period of monetary and exchange rate stability like that of the "stabilizing development" years from 1955 to 1970.
As a first step, the Banco de Mexico, with presidential approval, decided to go ahead with a unilateral target zone beginning in November 1991. The Banco de Mexico decreased the rate of pre-announced crawling devaluation for the purchase price of pesos and stipulated a freeze in the sale price. This widened the "bid-ask" spread in the interbank peso market. The strong positive market reaction to this move, evident in a nominal appreciation within the target zone, encouraged the Banco de Mexico to widen the band even further in March 1992. As part of the renegotiation of the tripartite wage and price agreement in November 1992 the band was further widened. 20
Destabilizing pressures on the exchange rate can be dealt with in a variety of ways. In fact, just as Federal Reserve and Banco de Mexico economists argued the merits of a target zone, other noted international economists argued against it. 21 The palatability of a multilaterally backed target zone had to do with Mexican government politicians' concerns about increasing the credibility of their commitment to policies designed to create a profitable investment environment. History had created a credibility problem, but its growing importance corresponded to rising competition for national credit and investment stemming from economic integration. The multilaterally backed target zone was attractive to policy makers both because it was desirable to purveyors of foreign exchange and capital in the short run and because of its longer-run credibility-enhancing effects.
Frieden argues that capitalists in developing (capital-scarce) countries will oppose policies that involve increased capital mobility because it will increase domestically available capital and lower the return to capital. Why, then, would Mexican bankers and large-scale industrialists historically have opposed exchange controls and currently support a multilaterally backed target zone? 22 Why also would bankers and large-scale industrialists support a policy that will generate a futures market, dampen the impact of actual or threatened capital flight, and thereby weaken their ability to influence policy?
The answer lies in the incentives created by growing integration. The ability to profit from relatively long-term business investments designed to exploit regional integration is limited by the need to preserve the capital flight option. For those contemplating investment in sectors that are positively affected by the rise in regional integration, such as auto parts, chemical products, petrochemicals, and glass, regional integration is raising the opportunity costs associated with keeping capital liquid. The greater these opportunity costs, the greater the extent to which threatened capital flight becomes a second-best strategy for dealing with an uncertain policy environment.
The target zone makes exchange-rate-related medium-to-long-term investment risks more directly a function of market conditions rather than capricious government action. It facilitates development of a peso futures market through which regionally operating busi nesses can cover their exchange risk. There is further incentive for business to support not only a more market-guided exchange rate policy but also a bilateral or multilateral agreement to back it. Such an agreement would presumably reduce the need for the disciplining use of capital flight. The target zone solution to exchange instability is attractive to government politicians for the potential impact it could have on the credibility of government policy commitments in the eyes of creditors and investors with international operations and options.
In the Mexican case, exchange rate history had created a credibility problem that constrained Mexican growth. International commitment and change in the central bank charter are part of an effort to make institutional changes in response to the constraint represented by low credibility. 23 The hope is that these institutions will then themselves become part of a new constraint that would increase credibility by signaling the government's willingness to make political sacrifices in the name of policy commitment. There is a further desire to facilitate a mutually reinforcing dynamic between international monetary and exchange rate commitment and increased central bank independence. 24
Under a floating exchange rate regime, a central bank theoretically has complete freedom in the monetary policy area; for example, there is no balance of payments or exchange rate constraint on central bank financing of government deficits. Under a fixed exchange rate regime with capital controls, a central bank also has considerable freedom in the conduct of monetary policy. But in a fixed or close to fixed system with no exchange controls, inflationary policies result in capital outflows and threaten the exchange rate. Depending on the flexibility in international exchange rate commitments, capital account convertibility can impose greater discipline on both monetary and fiscal policy. 25 In other words, if internationally committed on exchange rates, capital mobility reduces government freedom in the conduct of monetary and, to some extent, fiscal policy. 26 Government policies of raising revenue through seignorage or other forms of inflation tax lose viability, and this increases pressure to limit government spending. 27
A bilaterally or multilaterally negotiated exchange rate system would tie the hands of the central bank in the conduct of monetary policy and also impose constraints on government fiscal policy. It could increase the credibility of a government's commitment to sta bility-oriented macroeconomic policy. In more technical terms, it could help solve the classic time-inconsistency problem involved in discretionary conduct of monetary policy. 28
Mexican central bankers are interested in moving beyond the unilateral target zone to a bilateral or multilateral target zone agreement precisely because a unilaterally decided-upon target zone or peg does not have the full credibility-enhancing effects of a bilateral or multilateral agreement. In the case of a unilateral peg, adjustment to economic shocks would have to be borne by the pegging country alone. As an analyst of East European monetary problems points out, some asymmetry is necessary in order to achieve the disciplining effect of fixed or near-fixed exchange rate regimes, but multilateral schemes usually provide for some burden sharing in the case of short-term shocks. 29 One-sided exchange rate commitments are more likely to provoke speculative attacks. Second, multilateral agreements require the consent of all parties for exchange rate adjustment, making the target more credible than in the case of unilateral pegging.
The credibility-enhancing motive for international financial liberalization and cooperation is especially strong in low-income countries, which can least afford the expected output losses associated with stabilization. The more credible the government's anti-inflation policy, the less resistance from potential private-sector investors, both domestic and international. In other words, the more credible the government's macroeconomic policy, the shorter the time those contemplating new investments in Mexico wait before committing themselves. This is another way of saying that macroeconomic policy credibility reduces the inflation-output trade-off. Credibility can cut the output losses associated with anti-inflation campaigns.
Given the potential for reducing this inflation-output trade-off, it is not surprising that government macroeconomic policy credibility has also been cited as an important source of motivation for international monetary cooperation in South and East European cases. 30 In writing about the Spanish commitment to the EMS, a Banco de España official writes that joining the EMS increased public confidence in the government's anti-inflationary stance by altering the incentives for policy makers to pursue inflationary policies. 31 Similarly, in the Portuguese case there is the hope that external financial and monetary liberalization will enhance the credibility of government adjustment efforts. By joining a monetary union, writes a former Portuguese central bank economist, "the authorities 'tie their hands.' . . . Such an explicit external commitment to an exchange rate rule works domestically as a reputational constraint." 32
Related to a desire to use a multilaterally negotiated exchange rate regime to enhance the credibility of government commitment to macro-stability is the desire also to strengthen the credibility of the central bank, the main gatekeeper between the domestic and international economies. The 1991 annual report of the Federal Reserve Bank of Dallas highlights the role that exchange rate pegs could play in enhancing the credibility of Latin American central banks. Central bank independence, cautions the report, "may not be sufficient to restore credibility to monetary policy. If central banks can sustain low money growth . . . ," the report continues,
| fixed exchange rates may become unnecessary shackles. Until that time, however, Latin American governments may temper the power to print money with a strong constraint, such as some form of exchange rate regime whereby their currencies are linked to a low-inflation currency, like the U.S. dollar. 33 |
Similarly, changes in the legal independence of East European central banks are an important first step toward enhancing the credibility of those governments' stabilization and liberalization goals, but most economists agree that currency convertibility and multilateral exchange rate agreements will have to supplement domestic efforts. After analyzing the expected credibility impact of the various exchange rate regime options: a unilateral peg, EMS membership, or full currency union, a West German central banker concludes that, for many of the reasons outlined above, a multilaterally agreed-upon peg would provide the biggest boost to stabilization efforts in East Europe. 34 In these instances the idea is that multilateral agreements provide credibility to national central banks. The hope is that with an external rule binding monetary policy, and to some extent fiscal policy also, executive branch agencies and legislators involved in fiscal policy will become increasingly accustomed to respecting central bank authority on macroeconomic policy issues. The self-reinforcing recursive dynamic between the domestic and the international levels is evident: a more authoritative central bank is presumably a central bank better able to pursue future international financial liberalization and international monetary cooperation. In the West European situation, for example, the Bundesbank is expected to lend credibility to the multilateral monetary agreement.
This essay has examined the decision to increase the scope for market definition of Mexican exchange rates as part of an effort to illuminate the circumstances under which financial liberalization can be self-reinforcing. What are the conditions that might lead from a liberal policy regarding exchange convertibility to a higher probability for cooperative foreign monetary policy?
Regional and global integration put the issue of exchange stability on the agenda. The choice of a more market-guided exchange rate policy responded to the way integration increases government sensitivity to the need for credibility in the eyes of creditors and investors. By lessening the potential for arbitrary government decisions to affect investment and credit risk, the government hoped to increase the attractiveness of Mexico as an investment and credit site and signal its commitment to credibility-enhancing actions. The importance of credibility in the context of economic integration and the concomitant rise in international competition for capital drives a search for institutional changes that enhance credibility. A logical credibility-enhancing corollary to the target zone is multilateral cooperation on monetary and exchange rate policy. The decision to follow a more market-guided exchange rate policy in Mexico is likely to be accompanied by a sustained commitment to cooperative foreign monetary policy because both respond to the logic of growing economic integration. Economic integration increases the potential international investment options open to wealth holders. It also increases international competition for capital; this makes governments more sensitive to the need for credibility in the eyes of wealth holders. To an increasing extent, policies will be chosen for their anticipated impact on credibility and, through it, on capital flows. The importance of credibility, which drives stabilizing liberalization, is shaped by the extent to which international integration increases international competition for capital.
I thank Albert Fishlow, Jeffry Frieden, Judith Goldstein, Stephan Haggard, Ron Linden, several anonymous reviewers, and especially Miles Kahler for comments on earlier versions.
Note 1: See Katrina Burgess, "Fencing in the State: International Trade Agreements and Economic Reform in Mexico" (Princeton University, no date, mimeographed). Back.
Note 2: For an overview, see Adam Przeworski and Michael Wallerstein, "Structural Dependence of the State on Capital," American Political Science Review 82, no. 1 (1988). Back.
Note 3: Since the mid-1970s a number of developing countries have begun to reduce controls on private capital inflows and outflows, on the entry of foreign financial firms, and on the international operation of domestic financial enterprises. Restrictions on the international movement of capital can be categorized in several ways: most broadly, they can refer to capital inflows or capital outflows and/or to short-term or long-term capital flows. The actual methods of control can range from requirements for authorization of individual transactions involving cross-border capital movement to generalized controls on foreign currency exchange. Capital account liberalization is defined as the gradual elimination of national restrictions on foreign currency exchanges and other restrictions on international capital transfers. Foreign exchange controls are relatively easy to detect, and requirements for liberalization are clear. It is often harder to get a comprehensive picture of other national restrictions on capital flows. The OECD Capital Movements Code directs attention to operations that restrict the following: direct investment or disinvestment, buying and selling or "admission" of securities, operations in real estate, buying and selling of short-term securities normally dealt with in the money market, credits directly linked to international trade in goods or services, cross-border financial credits and loans, operation of accounts with credit institutions, personal capital transfers, physical movement of capital assets, and disposal of nonresident-owned funds. Back.
Note 4: On Mexican capital account controls, see Stephen Haggard and Sylvia Maxfield, "The Political Economy of Internationalization in the Developing Countries," International Organization 50, no. 1 (1996): 35-68. Back.
Note 5: Ricardo Torres Gaytan, Un siglo de devaluaciones del peso mexicano (Mexico City: Siglo Veintiuno Editores, 1982), p. 199. Back.
Note 6: Despite the end of the Bretton Woods fixed exchange rate regime in 1973, most developing countries kept their currencies fixed vis-á-vis the dominant currency in their region and/or in their trade relations. Back.
Note 7: For a review of this policy, see Stephen Zamora, "Exchange Control in Mexico: A Case Study in the Application of IMF Rules," Houston Journal of International Law 7, no. 1 (Autumn 1984): 103-106; Ignacio Gomez Palacio, "Mexico's Foreign Exchange Controls: Two Administrations, Two Solutions--Thorough and Benign," Inter-American Law Review 16, no. 2 (1984): 267-299. Back.
Note 8: Rolando Cordera and Carlos Tello, La disputa por la nacion (Mexico City: Siglo XXI, 1979). Back.
Note 9: Darryl McLeod and John H. Welch, "Free Trade and the Peso" (paper prepared for the 66th annual Western Economic Association International Conference, Seattle, July 1, 1991), fig. 2. Back.
Note 10: Mexican government officials are publicly committed to peso-dollar linkageof some kind. See "Mexican Trade Gap 'No Bar to Fixing Peso,"' Financial Times, November 5, 1991, p. 8. Back.
Note 11: Patricia Armendáriz, "Zonas de paridad cambiaria: El caso Europeo y una propuesta para Mexico" (October 1991, mimeographed). Back.
Note 12: For example, in April 1992 Nomura Securities moved $6 billion out of Mexico in one day with only a slight short-term change in the exchange rate. For more on this point, see McLeod and Welch, "Free Trade and the Peso." Back.
Note 13: See Tamin Bayoumi and Barry Eichengreen, "Monetary and Exchange Rate Arrangements for NAFTA" (paper prepared for the Interamerican Seminar on Macroeconomics, Buenos Aires, May 7-9, 1992). Back.
Note 14: Federal Reserve Bank of Kansas City, Policy Implications of Trade and Currency Zones: A Symposium Sponsored by the Federal Reserve Bank of Kansas City (Kansas City: Federal Reserve Bank of Kansas City, 1992). Back.
Note 15: One of the reasons the French supported monetary coordination was to raise the barrier to British entry into the common market. German support also had to do with the political goals of counterbalancing Eastern Europe and preparing for a less reliable U.S. role in Western European defense. Back.
Note 16: Loukas Tsoukalis, The Politics and Economics of European Monetary Integration (London: Allen and Unwin, 1977), p. 82. Back.
Note 17: See, for example, Jaime Ros, "Free Trade Area or Common Capital Market?" Journal of Interamerican Studies and World Affairs 34, no. 2 (Summer 1992): 53-92. Back.
Note 18: Of course, the sources of exchange rate instability in Mexico, a relatively small open economy, are at least partially different from the sources of exchange rate instability in Western Europe in the late 1960s. Exchange rate uncertainty has had a particularly negative impact on Mexican investment. For data on this, see McLeod and Welch, "Free Trade and the Peso." Back.
Note 19: Statement of Representative John J. la Falce, House Committee on Small Business hearings, "NAFTA and Peso Devaluation: A Problem for U.S. Exporters?" May 20, 1993; Richard Lawrence, "Exchange-Rate Policy Urged as One of NAFTA Side Deals," Journal of Commerce, May 21, 1993, p. 5. The other three supplemental agreements discussed by the United States, Canada, and Mexico covered environmental impact, labor standards, and "import surge" protection. Back.
Note 20: See Raul A. Feliz and John H. Welch, "The Credibility and Performance of Unilateral Target Zones: A Comparison of the Mexican and Chilean Cases" (paper prepared for the Western Economic Association International 68th Annual Conference, Lake Tahoe, June 20-24, 1993). Back.
Note 21: Rudiger Dornbusch, testimony to House Committee on Small Business hearings, "NAFTA and Peso Devaluation: A Problem for U.S. Exporters?" May 21, 1993. Back.
Note 22: "Bankers viewed an arrangement which decreased the Banco de Mexico's role in the foreign exchange markets as very positive," report Feliz and Welch ("The Credibility and Performance of Unilateral Target Zones," p. 3). Back.
Note 23: Sylvia Maxfield, Gatekeepers of Growth: The International Political Economy of Central Banking in Developing Countries (Princeton: Princeton University Press, 1997), ch. 6. Back.
Note 24: Mexicans hope both to get credibility from the U.S. Fed and to increase Mexico's ability to commit to cooperative monetary policy by increasing the independence of the Banco de Mexico. This reflects an implicit recognition of Woolley's argument that the EMS cannot hope to get credibility from the Bundesbank without demonstration by all participating governments of willingness to bear the political costs of monetary cooperation. As Bayoumi and Eichengreen note, the Bundesbank is probably a sounder anchor than the U.S. Fed. In the Mexican case, however, the value of any anchor is better than none (Bayoumi and Eichengreen, "Monetary and Exchange Rate Arrangements for NAFTA," p. 9). Back.
Note 25: Helmut Reisen, "Macroeconomic Policies Towards Capital Account Convertibility," in H. Reiser and B. Fischer, eds., Financial Opening: Policy Issues and Experiences in Developing Countries (Paris: OECD, 1993). Back.
Note 26: Tsoukalis, The Politics and Economics of European Monetary Integration, p. 38. Back.
Note 27: William H. Buiter and Kenneth M. Kletzer, "Reflections on the Fiscal Implications of a Common Currency," in A. Giovannini and C. Mayer, eds., European Financial Integration (New York: Cambridge University Press, 1991), p. 233. The economic logic behind this is that with an exchange rate peg, inflation-inducing macroeconomic policy would raise the foreign exchange price of domestically produced goods faster (depending on the extent of foreign inputs) than that of foreign goods. The nation's export ability would shrink, depending on price elasticity in foreign markets, while imports surged. This might lead to a decline in output and a rising trade deficit. To support the exchange rate at its pegged rate, the central bank would have to spend international currency reserves to purchase national currency and keep the currency's price up. Fears of devaluation and rising inflation would grow. Back.
Note 28: See Susanne Lohmann, "Optimal Commitment in Monetary Policy: Credibility Versus Flexibility," American Economic Review 82, no. 1 (March 1992): 273-286. Back.
Note 29: Peter Bofinger, "The Transition to Convertibility in Eastern Europe: A Monetary View," in J. Williamson, ed., Currency Convertibility in Eastern Europe (Washington, D.C.: Institute for International Economics, 1991), pp. 129-130. Back.
Note 30: For a rigorous presentation of the logic behind this argument, see Francesco Giavazzi and Marco Pagano, "The Advantage of Tying One's Hands: EMS Discipline and Central Bank Credibility," European Economic Review 32, no. 5 (1988): 1055-1082. Back.
Note 31: Jose Vinals, "The EMS, Spain, and Macroeconomic Policy," in P. de Grauwe and L. Papademos, eds., The European Monetary System in the 1990s (New York: Longman, 1990), p. 205. Also see Banco de España, "La incorporacion de la peseta al mecanismo de cambios del Sistema Monetario Europea," Boletin Economico (July-August 1989): 71-89; Juan Ayuso, "The Effects of the Peseta Joining the ERM on the Volatility of Spanish Financial Variables" (Banco de España, Servicio de Estudios, Documento de Trabajo no. 9106). Back.
Note 32: Francisco Torres, "Portugal, the EMS, and 1992: Stabilization and Liberalization," in de Grauwe and Papademos, The European Monetary System in the 1990s, p. 228. Back.
Note 33: Federal Reserve Bank of Dallas, Federal Reserve Bank of Dallas 1991 Annual Report: Economic Liberalization in the Americas (Dallas: Federal Reserve Bank of Dallas, 1992), p. 13. Back.
Note 34: Bofinger, "The Transition to Convertibility in Eastern Europe," p. 138. Back.
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