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TheMexicanReformProcess:ImprovingLong-RunPerspectivesandMasteringShort-RunTurbulences

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Langhammer, Rolf J.; Schweickert, Rainer

Working Paper

The Mexican reform process : improving long-runperspectives and mastering short-run turbulences

Kieler Diskussionsbeiträge, No. 255

Provided in Cooperation with:Kiel Institute for the World Economy (IfW)

Suggested Citation: Langhammer, Rolf J.; Schweickert, Rainer (1995) : The Mexican reformprocess : improving long-run perspectives and mastering short-run turbulences, KielerDiskussionsbeiträge, No. 255, http://hdl.handle.net/10419/841

KIELER DISKUSSIONSBEITRAGE

K I E L D I S C U S S I O N P A P E R S

The Mexican Reform Process: Improving Long-RunPerspectives and Mastering Short-Run Turbulences

C O N T E N T S

by Rolf J. Langhammer and Rainer Schweickert

Mexico's recent financial crisis, culminating in December 1994, threatens the positiveeffects of the substantial reforms that the country has implemented since 1985 byopenning its real sector: first trade has been liberalized unilaterally, then Mexico has joinedthe GATT, the Uruguay Round, the NAFTA and recently the OECD and thus has commit-ted itself to internationally binding rules and liberalization schedules. Furthermore,foreign direct investment has been invited to formerly closed sectors. With thesereforms, Mexico has succeeded in establishing a solid base for a sustainable take-off.

However, both the legacies of past distortions and the effects of its exchange-rate-based stabilization policy have prevented Mexico from fully harvesting the fruits of itsreform efforts. Capital productivity still warrants improvement, investment und domesticsavings ratios are lower than in Asia and in the Latin American "success story" Chile.In merchandise trade, non-traditional exports and import-competing domestic indu-stries have suffered from real appreciation.

FDI flows to Mexico rose after adjustment programmes were implemented. However,absolute increases cannot obscure the fact that Mexico's position in US foreign directinvestment (the major source of FDI inflows) only recovered to levels already achievedprior to the debt crisis in 1982. German and particularly Japanese investment remainedbelow this level and even declined in relative terms. Furthermore, there are structural vul-nerabilities: Mexico's industrial exports and inward foreign investment heavily concen-trate on the motor vehicle industry, which exposes the country to short-term fluctuationsin consumer demand for cars, particularly in the United States. In total, even before theDecember 1994 crisis, Mexico was not as attractive a host to FDI as newly industrializingcountries in Asia or transformation economies in Europe.

Both external factors (increase in US interest rates) and political events (regional upheav-als, the assassination of the presidential candidate, elections) led to the outbreak of thefinancial crisis in December 1994. Yet, the Mexican exchange-rate-based stabilizationstrategy can be regarded as the real cause of the crisis. This strategy entailed high risksand was also implemented in an inconsistent way: the so-called Pacto agreements fail-ed to provide sufficiently restrictive monetary and wage policies, the fiscal surplus wasachieved by cutting public investment rather than taxing consumption, and factor marketderegulation was delayed.

1995 forecasts of high inflation and negative GDP growth show that Mexico has enteredthe "bust" phase of exchange-rate-based stabilization strategies. The only short-run optionis to continue the present float of the Peso and to establish the credibility of the money sup-ply target. In the medium run, Chile's passive crawl with wide bands provides a blueprintfor a low-risk exchange rate management.

Without re-establishing the credibility of monetary policies, the gains from real sector reformswill not materialize. Yet, even with credibility, Mexico has to remove several bottlenecks, e.g.,in human cpital and infrastructure before it can fully reap the gains from previous reforms.

I N S T I T U T F U R W E L T W I R T S C H A F T K I E L A U G U S T 1 9 9 5

ISSN 0455-0420

Contents

I. Introduction 3

II. Long-Run Perspectives: The Real Side 4

1. Trade Perspectives 4

a. Reform of the Trading Regime 4

b. Regional Integration: The NAFTA Framework 7

c. Worldwide Integration: The WTO Framework 10

2 Investment Perspectives 14

a. Domestic Resource Mobilization and Allocation 14

b. Structure of Capital Inflows 16

c. Attractiveness for Foreign Direct Investment 17

3. Policy Recommendations 19

m . Short-Run Distortions: The Monetary Side 21

1. The Failure of Exchange-Rate-Based Stabilization 21

a. Stabilization versus Structural Adjustment 21

b. Complementary Policy Measures 23

2. Alternative Strategies for Macroeconomic Management 28

a. Implementing a Sustainable Fixed Exchange Rate 28

b. Rule-Based Management of a Flexible Exchange Rate 30

3. Policy Recommendations 31

IV. Perspectives and Policy Recommendations 32

Appendix: Stylized Facts about Exchange-Rate-Based Stabilization 33

Bibliography 37

The study was commissioned by the Camara Mexicano—Alemana de Comercio e Industria.

Die Deutsche Bibliothek - CIP-EinheitsaufnahmeLanghammer, Rolf J.:The Mexican reform process : improving long-run perspectivesand mastering short-run turbulences / by Rolf J. Langhammerand Rainer Schweickert. Institut fur Weltwirtschaft Kiel. - Kiel: Inst. fur Weltwirtschaft, 1995

(Kiel discussion papers ; 255)ISBN 3-89456-101-7

NE: Schweickert, Rainer:; Kieler Diskussionsbeitrage

©Institut fur Weltwirtschaft an der Universitat Kiel

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Ohne ausdruckliche Genehmigung ist es auch nichtgestattet, den Band oder Teile daraus

auf photomechanischem Wege (Photokopie, Mikrokopie) zu vervielfaltigenPrinted in GermanyISSN 0455 - 0420

I. Introduction

Since many years, Mexico has been groupedamong the six so-called first generation NICs(newly industrializing countries), jointly withBrazil as the only other Latin American countryand the four East Asian economies .of HongKong, Korea, Singapore and Taiwan (OECD1988: 11). However, contrary to the East Asianmembers of the group, economic growth washampered by macroeconomic mismanagement.The debt crisis of the early eighties marked thebeginning of an unprecedented depression. Torecover from this decline proved to be among themost painful experiences of structural adjust-ment in all indebted developing countries. Yet,Mexico mastered the challenge with a strongcredible package of economic, social and insti-tutional reforms initiated in the second half ofthe eighties. By the early nineties, it then becamea major host of foreign capital again.

This economic progress, which was achievedduring the last decade, is presently jeopardizedby the financial crisis that broke out in Decem-ber 1994. To overcome the crisis requires thatthe short-run turbulences be mastered. This is anecessary condition for Mexico to return to asustainable growth path. At the same time, thereis scope to improve the long-run perspectives.Given the size of its economy, Mexico — afterBrazil — has always ranked second among thesix first-generation NICs in terms of share inworld GDP and world manufacturing valueadded but, like Brazil, failed to defend the sameranking as concerns world trade. Asian NICseasily bypassed Mexico from the early seventiesonwards as dynamic exporters of goods andservices. Therefore, policies have to be dis-cussed that contribute to reduce erratic fluctua-tions, to improve the international competitive-ness of Mexican factors of production and toallow trickling down effects of growth to be-come effective to the low-income segments ofthe electorate. The latter is of considerable im-portance for achieving social coherence andpeace. Ultimately, Mexican policies will have toaim at including as many private households andcompanies in a developmental growth coalition

as possible. East Asian countries bear witness tothe importance of such broad growth coalitions,which contribute to mobilize domestic savingsand to allocate financial resources efficiently.

Hence, the long-run perspectives affectingMexican trade and investment under interna-tional locational competition for mobile re-sources will be given priority in this study.Chapter II discusses the medium-term perspec-tives in the real sector that were perceived asachievable before the crisis broke out. Perspec-tives for trade expansion emerged from threelayers: from domestic structural adjustment,from commitments toward trade liberalizationwithin the North American Free Trade Agree-ment (NAFTA) and, finally, from prospects forMexico offered by the successful conclusion ofthe multilateral trade negotiations. However, theextent to which these options could be used wereconditioned by productivity increases followingthe modernization of the capital stock. Evidencesuggests that it is foreign direct investment thatplays a major role in this respect. Hence, thesecond part of Chapter II concentrates on theattractiveness of Mexico for private risk capitalfrom abroad relative to competing hosts, forinstance, in Latin America and East Asia. It willbe shown that in the past Mexico suffered fromrelatively low productivity of total investmentand that one can expect a rebound in outputgrowth once obsolete capital is fully replaced bynew more productive equipment.

Chapter III is devoted to the key prerequisiteof realizing options in the real sector: consistent,stable and credible macroeconomic managementthat is instrumental to cut inflation and to stabi-lize the real exchange rate. For this purpose, it isnecessary first to discuss reasons for the failureof past exchange rate stabilization in Mexico. Inthis respect, it has to be distinguished between"natural" risks, which are inherent and systemicin each exchange-rate-based stabilization pro-gramme, and "policy-induced" risks, which stemfrom inconsistent implementation. The secondpart of Chapter III discusses two alternativeconcepts for returning to exchange rate stabiliza-

tion: first, a renewed fixing of the exchange ratein a currency board framework and second, arule-based exchange rate management allowingexchange rate flexibility, hi assessing the rela-

tive merits of the two approaches, experiences ofother developing countries are taken into ac-count. Chapter IV concludes with the results.

II. Long-Run Perspectives: The Real Side

1. Trade Perspectives

a. Reform of the Trading Regime

Next to Brazil, Mexico is the largest singleeconomy in the group of upper-middle incomecountries. Measured at current exchange rates in1992 dollars, it just keeps the median position inper capita income in this group of twenty coun-tries, hi purchasing power parity (PPP dollars),it more than doubles its per capita income andapproaches one-third of the US income. Post-war experience suggests that countries of thissize have been tempted to pursue inward-lookingtrade policies relying on quantitative restrictionsmuch longer than smaller countries with moreexposure to world markets have, hi addition,these large economies were often commodity-rich and hence preferred to exploit "natural"rents instead of making their human and capitalresources internationally competitive. Even iftheir governments understood the "two-edgedsword" role of commodity abundance in eco-nomic development and tried to minimize exoge-nous shocks emerging from the commodity sec-tor, they often had to cope with Dutch-diseasesyndromes impeding export diversification ef-forts. Finally, whenever inward-lookingness be-came unsustainable, trade reform endeavourswere usually more half-hearted and less consis-tent than in other much smaller resource-pooreconomies.

hi many instances, Mexico's post-war devel-opment reflects this pattern, though the eaiiyexport diversification through "border indus-tries" adjacent to the United States may speakagainst this hypothesis. However, offshore as-sembly zones isolated from the policy conditionsprevailing in the rest of the economy operated inmany countries but did not change the inward-

ness of the entire economy. Their main short-coming was that, due to unchanged import sub-stitution policies in the rest of the economy, theyneither used inputs from the rest of the countrybecause these inputs were noncompetitive. Nordid they compete with the output produced underimport substitution strategies. Hence, the effectsof such zones on the rest of the economy interms of productivity increases remained verylimited. Mexico operated such a trading regimeuntil the mid-eighties.

Trade Policy Reform as a Cornerstone ofStructural Adjustment in Mexico

hi 1985, first major steps in trade policy reformwere taken (Nash 1991: 495-504). Their latersuccess was much determined by the fact thatfrom the very beginning exchange rate measureswere part of the reform, hi July 1985, the gov-ernment announced a 20 per cent devaluation ofthe controlled exchange rate, followed by thestart of a managed floating exchange rate and anacceleration of the nominal depreciation rate.Still a dual exchange rate system was main-tained but rates were managed in a way to pre-pare for currency unification. The trading re-gime in its narrower sense was shaped almostsimultaneously (July 1985) by rolling backquantitative restrictions. As a follow-up, GATTmembership was requested in 1986 (see SectionII.l.c), the maximum tariff was reduced from100 to 50 per cent, quantitative restrictions(measured as equivalents of domestic produc-tion) were announced to be redressed in a step-wise approach, and reference prices on importswere eliminated to comply with GATT anti-dumping procedures.

Trade policy reforms not only embarked uponimport liberalization as a means to lower theimplicit tax on exports. To directly foster ex-

ports, also export promotion measures (for ex-ample, rebating duties and indirect taxes, remov-ing quantitative export controls, consolidatingexport financing) were adopted with the supportof World Bank export development loans. Indi-rect and direct export orientation became notonly accepted as a strategy to earn foreign ex-change in a period when oil prices dropped. Itwas also disseminated nationwide as a way tocontain inflation and to ensure the success ofmonetary stabilization. It is important to notethat grave effects on import-substituting indus-tries were either mitigated by simultaneous de-preciation or by substituting nontariff measuresfor tariff measures, hi some cases, measures arereported to have been symbolic only, as theywere not binding at the time of reforms. Becauseof depreciation (1981-1987), Mexico becameone of the most competitive suppliers among thedeveloping countries in terms of wage costs butfailed to stabilize the real exchange rate. Growthof exports in dollar terms could not be sustainedafter 1987, when the peso began to appreciate inreal terms. As a result, between 1985 and 1992,dollar-denominated exports (excluding maquila-dora industries) rose by 3.5 per cent annuallyonly, while imports rose by more than 20 percent (UN/ECLA 1994: 283).

Even if we exclude the exceptional 1990-1992 period (when massive capital inflows easedbudget constraints and let import demand in-crease overproportionately) and concentrate on1985-1990 only, annual rates of export growthamounted to 4.4 per cent only compared with18.8 per cent on the import side. One may ex-plain this gap with the usually delayed reactionof export volumes relative to import volumeswhen trade is liberalized, but it may also indi-cate a structural vulnerability of the Mexicanexport supply, both regionally and sectorally.Regionally, the US market absorbs major partsof the Mexican supply even if we disregard themaquiladora industries.1 Therefore, a recessionin this market, as at the turn of the decade, af-fects the Mexican export industry severely. Riskspreading by shifting export supply to othermarkets has not yet been achieved as much as itseems necessary. Sectorally, Mexican noncom-modity export supply is dominated by metal

manufacturing, basically the motor vehicle in-dustry: in 1992, about one-third of manufactur-ing exports (one-fifth of total exports) consistedof exports of the motor-vehicle industry. Again,together with the regional focus, this compoundsthe dependence on US business cycles becauseoutput in this industry is largely determined byfinal consumer demand and, as a durable con-sumer good, by easy access to consumer creditsin the United States. Unlike Asian countries,which increasingly export capital goods andintermediates with a larger regional spread andwhich seem to have reduced a single market-single industry dependence, Mexico is stronglyexposed to determinants of US demand for du-rable consumer goods.

Hence, the necessity for product innovation(up-grading, diversification) and for the searchfor new markets outside the United States isgiven. It is important to mention in this contextthat product innovation itself depends on raisingthe skill content in products. Therefore, humancapital formation and improvement emerges asone of the most demanding prerequisites of sus-tainable structural adjustment in Mexico. Thisholds the more as real appreciation in recentyears has contributed to making existing pro-duction techniques obsolete, and new technolo-gies incorporated in foreign direct investment(FDI), for instance, will replace them. As con-cerns policies towards FDI, reforms in 1989 ledto substantial liberalization with respect to sec-tor coverage, automatic approval and 100 percent foreign ownership. About two-thirds ofGDP is estimated to be unrestricted for FDI(GATT 1993: 62). Remaining categories ofrestricted activities include not only the energysector, which is reserved for the state, but alsoextractive industries and some manufacturingindustries (secondary petrochemicals, auto partsand related industries) in which nonresidents arenot allowed to hold equity of more than 30 percent and 40 per cent respectively. It can be ex-pected that remaining restrictions are binding inthe sense that relaxing them would attract moreforeign investment to Mexico.

To increase productivity in the new capitalstock and to make full use of FDI for the Mexi-can economy, new technologies must be com-

plemented by joint quality improvements on thelabour side, i.e., employing more skilled andflexible workers. This includes not only school-ing improvements but also, again demonstratedby the Asian example, improvements in learningon the job. Structural adjustment, thus, shouldbe targeted at high employment levels in order toenable large parts of the labour force to improvetheir skills on the job.

Challenges to Mexico's Trading Regime

Mexico has substantially streamlined and lib-eralized its trading regime since 1985. Despitethis achievement, Mexico will cope with a num-ber of challenges unilaterally, regionally andmultilaterally in the future. First, unilaterally, inits own interest, Mexico will have to give distri-butional targets greater attention (for regionaland multilateral challenges see Section Il.l.band c). This is not to say that equity and effi-ciency are trade-offs, hi many developing coun-tries, distributional aspects of policy reformshave proven to be essential for overall accep-tance in the electorate and for active participa-tion in middle-class growth coalitions. Suchaspects can be considered by institutionalizednegotiations (pacto agreements; for these agree-ments see Section HI.l) to ensure concerted ac-tions of interest groups. Latin America in gen-eral and Mexico in particular share a large expe-rience with this approach. Alternatively, deliber-ate policy measures can be taken (or given up)to allow hitherto discriminated groups to partici-pate in the market process and to mobilize idleresources. Policy measures to protect agro-basedindustries from international competition, forinstance, in the sugar industry, bear largemedium-term opportunity costs because of ne-glecting the agricultural sector as a source ofincome generation and foreign exchange earn-ings. An important element of more equity inMexico's income distribution will therefore be tolink the potential of the rural sector (includingrural-based industries) to the rest of the econ-omy. Agricultural liberalization after concludingthe Uruguay round will help to provide precon-ditions for the expansion of agricultural ex-ports.2

Second, another challenge is to master inter-national tendencies toward stricter technical andenvironmental standards, including stricter mini-mum norms concerning intellectual propertyrights. Mexico has become a target of extraterri-torially enforced norms in the tuna dispute withthe United States and found its view supportedthat unilateral measures violate the GATT.However, multilaterally negotiated standardsmeet the rules of the World Trade Organization(WTO) and bear costs for Mexico in terms oftechnological up-grading of plants and pro-cesses. Burden sharing with foreign investorswould be the best strategy for Mexico but isconditioned by Mexico's continuing attractive-ness as a host for foreign risk capital (see Sec-tion II.2).

Third, Mexico faces a challenge of success. Ithas become a rapidly growing exporter of non-factor services. Among such services, consumerservices (in particular travel expenditures ofnonresidents) have accounted for a rising sharein total exports of goods and services. In 1985,foreign exchange income from travel expendi-tures accounted for 10.6 per cent of Mexicantotal exports, while seven years later this sharerose to 14.5 per cent (UN/ECLA 1994: 283). hiother nonfactor services, mainly business serv-ices, Mexico has shown a similarly good per-formance: the share of miscellaneous nonfactorservices (except travel and transport) in totalMexican exports doubled from 8 to 16 per centduring the same period, hi fact, Mexico has todefend a position as the leading Latin Americanexporter of commercial services, far ahead ofBrazil and at the same level as Taiwan and Ko-rea (GATT 1994a: Table 9). To defend thisposition, further policy actions toward the lib-eralization of market access for nonresidents tothe Mexican service sector are required, hi addi-tion, rapid technological change in service indus-tries, especially in telecommunication, has im-plications for capital formation, both human andphysical. Again, the financial burden shouldpreferably be shared between residents and non-residents by attracting foreign risk capital.

b. Regional Integration: The NAFTAFramework

Mexican Gains from NAFTA

Unlike many other integration schemes in whichdeveloping countries participated over the lastthirty years, NAFTA is far from being a redun-dant grouping. Instead, next to the EC-1992single market programme, it can be labelled asthe most effective endeavour to regional integra-tion so far. For Mexico, NAFTA was the logicalinstitutional complement and follow-up of itsvery intensive economic relations with theUnited States in trade and factor flows, hi fact,the US share of 70 per cent in Mexican tradesuggests the United States to be the naturaltrading partner for Mexico due to mutual com-plementarity in resource endowment, geographi-cal proximity and large absorptive capacity ofthe US market. Prior to NAFTA, the growth ofmaquiladora industries, based on US offshoreassembly provisions, had already provided agood momentum for exploiting such complemen-tarity but this sort of liberalization was one-sided and not mutual, and it was regionally andsectorally limited. A full-fledged free trade area

(FTA) comprising not only manufactures butalso agriculture and services, free capital flowsplus the Canadian membership was a substan-tially new institutional underpinning.

Under such conditions, economic theory pre-dicts that a FTA leads the periphery low-incomecountry to emerge as a net beneficiary (Ohr1995). It will gain easier access to goods mar-kets of the core country in relatively labour-intensive and resource-intensive products, and itwill import know-how and capital through capi-tal goods imports and FDI. Real convergence inper capita income levels between the centre andthe periphery should occur provided that theperiphery country refrains from domestic poli-cies that make local factors of production artifi-cially expensive and noncompetitive.

All quantitative assessments on magnitudeand regional distribution of net benefits fromNAFTA clearly earmarked Mexico as the majorgainer before the crisis broke out. Tables 1 and2 summarize these assessments with respect tochanges in real income and trade, respectively.The unanimous finding with respect to changesin real income was, irrespective of the empirical

Table 1 - Effects of NAFTA on Real Income (in per cent)a

Static models: perfect competition and CRS"3 technology

KPMG Peat Marwick

(1) (2)

Berkeley

(1) (2)

Roland-Hoist et al.c

(1) (2)

Trela and Whalleyd

(3a) (3b)

Effects on:MexicoCanadaUnited States

0.3n.a.0.02

4.6n.a.0.04

0.3n.a.0

6.4n.a.0.1

2.34.91.7

n.a.n.a.n.a.

1.2n.a.0.01

1.6n.a.0.01

Static models: imperfect competition and IRSe technology

Cox and Harris'

(1)

Effects on:MexicoCanadaUnited States

n.a.3.11n.a.

SobarzoS

tariff removal

2.0n.a.n.a.

Roland-Hoist et al.a

(4a) (4b)

2.54.11.6

3.36.82.6

1.60.70.1

BSD

(1) (2)

5.00.70.3

aSpecific assumptions on liberalization measures are denoted as follows: (1) = removal of tariffs; (2) = (1) plus expansionof import quotas plus liberalization of foreign direct investment inflows; (3) = removal of import quotas for textiles(variant a) or steel (variant b); (4) = removal of NAFTA tariffs and NTBs under Coumot competition (variant a) and con-testable markets (variant b). — "CRS = constant returns to scale. — cRoland-Holst et al. (1992), cited in Brown et al.(1992). Roland-Hoist et al. keep foreign direct investment constant. — dTrela and Whalley (1992). — eIRS = increasingreturns to scale. — feox and Harris (1992). — SSobarzo (1992).

Table 2 - Trade Effects of the US-Mexico Free Trade Agreement (in billions of $)

Balance of tradeUnited StatesMexico

US exports toMexicoRoW

Mexican exports to theUnited StatesRoW

Canadianexportsimports

RoWexportsimports

Balance of tradeUnited StatesMexico

US exports toMexicoRoW

Mexican exports to theUnited StatesRoW

rrca

0.00.0

2.030.15

2.170.15

n.a.n.a.

n.a.n.a.

Almonb Brown et al.c

Removal of tariffs and NTBs

1988

7.8-2.9

9.11.0

2.91.0

n.a.n.a.

n.a.n.a.

KPMG Marwickd CJ£MEX/WEFAe

-0.20.0

2.9-

2.9—

0.00.0

-0.1-0.3

ESIf

Investment in Mexico

of $25 billion in1988 only

0.00.0

2.830.51

2.760.80

of $40 billion in1991-2000

n.a.-19

54n.a.

50n.a.

of $25 billion in1992-2000

8 to -13n.a.

70n.a.

63 to 84n.a.

aUS International Trade Commission (1991). — bAlmon (1990), cited in Prestowitz, Jr.,''Brown et al. (1992: Table 5). Scenario (c)ico, plus a 25 per cent

For comparison:

actual trade flows

1989

_-

25.0338.9

16.16.9

120.7117.4

1,620.01,602.2

Hinojosa-Ojeda andRobinson^

of $12.5 billion

-A.I7.7

5.311.14

1.71-1.47

and Cohen (1991: 36-39). —assumes the removal of tariffs on trade between the United States and Mex-

expansion of US import quotas imposed on Mexican exports ofclothing. —dKPMG Peat Marwick (1991), cited in Prestowitz, Jr., and Cohen (1991: 38).in Prestowitz, Jr., and Cohen (1991: 38).Prestowitz, Jr., and Cohen (1991: 4 5 ^ 9 ) ,the world.

— 'ESI (The Economic Strategy Institute o:

igriculture, food, textiles, and— eAdams et al. (1991), cited" Washington, D.C.), cited in

Cohen (1991). — SHinojosa-Ojeda and Robinson (1991). — RoW = rest of

Source: See footnotes a-g and IMF (1991).

concepts applied, that Mexico was expected toenjoy larger gains in real income than the UnitedStates and, except for one study, Canada, too(Table 1). Findings for the trade side are not asclear. Not surprisingly, Mexican exports to theUnited States would expand further but givendeeper liberalization on the Mexican side thanon the US side and strong demand for US capitalgoods, Mexican imports from the United States

were expected to rise, too. Hence, studies werenot uniform on the Mexican trade balance due toNAFTA (Table 2). However, even if Mexicanimport expansion would have been dominated bycapital goods and not by consumer goods, atrade deficit would have signalled positive ef-fects for Mexico as the capital stock would bemodernized.

Exchange Rate and NAFTA Liberalization

The positive assessment of NAFTA for Mexicobecame subject to revision when the peso con-tinued to appreciate in real terms. Real appre-ciation (see Chapter III) turned out to be a clearimpediment to Mexican exports and made im-ports from the United States very much cheaper,hi this respect, it acted as a substitute to importliberalization. Domestic suppliers producingimport-competing goods faced fierce competitionfrom US products when they were confrontedwith slow growth of domestic demand, highborrowing costs and cost-price squeeze. Politi-cally, domestic opposition against implementingor even further accelerating intra-NAFTAscheduled tariff reductions can only be recon-ciled if the peso is allowed to find a new stablelevel. The present floating can be expected tohelp Mexican exports to penetrate dollar mar-kets. It would also relax price competition fordomestic suppliers, thus making them more pre-pared to accept further tariff cuts withinNAFTA. To private households, good newsfrom tariff cuts after depreciation could be con-veyed, as such cuts would help to counteractinflationary pressures arising from depreciation.

Partner Countries' Assistance to Mexico withinthe NAFTA Framework

The best support NAFTA partner countries canoffer to Mexico is to help the country to earnforeign exchange. The instruments are available:the United States and Canada can acceleratetheir schedules for stepwise dismantling tariffsand nontariff barriers (NTBs) in "sensitive"manufactures and agriculture. If the exchangerate disequilibrium is corrected, Mexico canfollow suit. The trade parts of the EuropeAgreements of the EU with Central and EasternEuropean Countries (CEECs) are examples forsuch asymmetric liberalization between periph-ery and centre. It is consistent with GATT pro-vided that in the later part of the liberalizationperiod the periphery catches up in its liberaliza-tion and arrives at par at the end. hi the absenceof exchange rate disequilibrium, a symmetricprocedure would probably be enforceable. Over-all, accelerating cuts of tariffs and quotas in allpartner countries would be the most credible

signal that the Mexican crisis has no impact onNAFTA.

A further lesson from the Europe Agreementsare antidumping procedures. Even without ne-gotiating a common competition law or allowingnonresidents to invoke national competitionlaws, the accelerated trade liberalization canhelp to abandon antidumping procedures againstMexico. Predatory dumping (selling below mar-ginal costs) and also cyclical dumping (sellingbelow average costs) becomes increasingly un-likely if goods markets are liberalized and na-tional oligopolies or monopolies disappear. TheUnited States and Canada can do more by ex-plicitly renouncing to apply antidumping proce-dures for the time being.3 Mutual recognition ofnational standards (origin country principle)would also be helpful to trigger Mexico's com-petitiveness within NAFTA. So would liberali-zation of public procurement.

Finally, intra-NAFTA liberalization becomesobsolete if there are infrastructural and bureau-cratic bottlenecks at the Mexican-US border.Apart from building new hardware, early liber-alization of transit procedures and commutertraffic plus recognition of preshipment certifi-cates would not only contribute to faster Mexi-can exports but would also increase the com-petitiveness of Mexican suppliers of transportservices within total NAFTA.

The Widening of NAFTA

Strategies of the deepening of NAFTA entail therisk to substantiate the traditionally very strongfocus of Latin American traders on the NorthAmerican market and to become decoupled fromother absorptive markets (East Asia, the EU orintra-Latin American trade). The best insurancefor Mexico against becoming captured in theNAFTA market is to widen NAFTA officiallytoward Central and other Latin American coun-tries, or, alternatively, to extend NAFTA rulesto nonwestern Hemisphere countries, i.e., the EUor East Asia. The former strategy is more easilyaccessible given bilateral trade agreements ofMexico with other Latin American countries andgiven the US "hub-and-spoke" approach in theBush initiative. Yet, economically, it is less at-tractive for Mexico, as the trade potential within

10

Latin America is somewhat lower than its poten-tial in trading outside the Americas.

Additionally, trade patterns still differ signifi-cantly between Mexican exports to the UnitedStates and, e.g., its exports to Europe. Trade inincome-elastic manufactures dominates in theexports to the United States, while commodity-based products account for a larger share inexports to Europe. At a time when the EU isconsidering launching a new policy for tradingwith Latin America that includes bilateral tradeagreements with Latin American countries,Mexico could initiate a bilateral free trade ar-rangement without violating NAFTA rules justas the US continues the double track of its freetrade agreement with Canada parallel toNAFTA. Orientation to the EU market wouldnot only help to diversify the export structure. Itwould also be instrumental to spread exchangerisks if the ecu/dollar exchange rate offsets priceeffects of the peso/dollar rate. Yet, as long as thedollar depreciates against the EU currencies andthe peso depreciates against the dollar, exportsto Europe may gain enough momentum even inthe absence of tariff cuts (unless price advan-tages are offset by large dependence on EUsourcing becoming more expensive), hi thissituation, bilateral tariff reductions betweenMexico and the EU may produce little additionaleffects compared with a situation in which theecu/dollar rate diverges from the peso/dollarrate. The institutionally rigid way of bilateralFTAs is unlikely to be the appropriate way tointensify trade with Asian countries which tra-ditionally shy away from legalized regionalism.The multilateral way (see next chapter) seemsmore recommendable for regarding trade withthese countries.

c. Worldwide Integration: The WTOFramework

Mexican Trade Policies Applied andCommitted

Since becoming a party to the GATT in 1986,Mexico has actively participated as a Contract-ing Party, both by liberalizing unilaterally andby contributing to the multilateral trade negotia-tions under the Uruguay round, hi fact, remov-

ing tariff barriers j binding tariffs "and disman-tling nontariff restrictions on imports, such as apriori import licenses, proved to be among thecornerstones of structural adjustment pro-grammes in the second half of the eighties. As aresult, pre-Uruguay round applied tariff rateswere cut to an average of 13 per cent and boundat a rate of 50 per cent. Hence, the margin be-tween applied and bound rates remained fairlyhigh, thus allowing discretionary tariff ratechanges without impairing GATT rules. Com-pared with 1982, when 100 per cent of tarifflines were subject to import licensing, only lessthan 2 per cent were still affected by this meas-ure ten years later. Furthermore, direct exportsubsidizes and fiscal incentives were eliminated,while agricultural subsidies were reduced. Anti-dumping procedures, one of the great shortcom-ings of the GATT, have been assessed as rela-tively clear and transparent (GATT 1993: 7).

Yet, in spite of these remarkable achieve-ments, rationalizing trade policies has still fallenshort of completeness. Apart from large marginsbetween applied and bound tariff rates, tariffescalation by the degree of processing has stillbeen maintained, thus protecting domestic valueadded in finished goods more than indicated bynominal legal rates. Table 3 illustrates tariffescalation with increasing stage of processing,as well as large tariff dispersion within indus-tries. Variable levies and seasonal tariffs havebeen imposed upon some agricultural products.Other sectorally discriminating import restric-tions have protected the local motor vehicle in-

Table 3 - Characteristics of Mexican Applied NominalTariff Rates, 1991/92 (in per cent)

Total broad sectorsPetroleumAgricultureIndustry

By stage ofprocessing9

TotalRaw materialsSemimanufac-

tured goodsFinished goods

Number ofobserva-

tions

122261

98011245

7,768802

43052,661

Mean

1310

13.713

12.610.8

11.415.0

Dispersion

33.9n.a.

46.0323

35.757.4

28.132.0

Xjroups comprising more than one processing stage.

Minimum

01000

00

00

Maximum

20102020

2020

2020

Source: GATT (1993: 76,190).

11

Table 4 - Tariff Commitments of Mexico under the Uruguay Round

MexicoFor comparison:Developing

countriesDeveloped

countries

Trade weighted tariff averages (boundtariffs) in per cent

pre-Uruguayround

post-Uruguayround

46.1 33.7

15.3 12.3

6.3 3.9

reduction

27

20

39

Percentage bound

pre-Uruguayround

100

15

94

post-Uruguayround

100

58

99

Percentage of imports duty-free

pre-Uruguayround

post-Uruguayround

0 1

52 49

20 44

Source: Hoda (1994: Tables 1-6), GATT (1994b, Appendix Table 2-6).

dustry, i.e., import ceilings, foreign exchangebalance requirements, local content rules andrestrictions on foreign investment.

The overall positive judgement on Mexico'sunilateral trade policy reforms had not to berevised when the country tabled its offers in theUruguay round. Apart from commitments in allmajor elements of rule-making (reforms ofGATT/WTO legal framework), rule-enforce-ment (streamlining dispute settlement), and ex-tension of legal scope of GATT/WTO (TRIMS,TRIPS, services), Mexico has offered to cutbound tariffs by an average of 27 per cent.Hence, post-Uruguay round tariffs will amountto 33.7 per cent (Table 4), thus substantiallyreducing the margin between applied and boundrates. Furthermore, there has been no change asregards the complete binding of all tariff lines.Compared with offers of all developing coun-tries, Mexico scores well. Its depth of tariff cutsand the percentage of bound tariffs are muchhigher than those of other developing countries,thus protecting investors against risks of short-term tariff manoeuvring. However, given Mex-ico's new status as an OECD member state(since 1994), the comparison with developedcountries is more demanding and relevant, hithis perspective, some desiderata emerge fromTable 4. Mexico is still far from one-digit boundrates achieved by other OECD countries, andalso its reduction rate in the Uruguay round islower than the OECD average, hi addition,commitments to guarantee duty-free treatment toimports cover but a very small share of all im-ports (only 1 per cent of total imports) — evencompared with developing countries — while, in

practice, duty-free treatment is much more ap-plied (19 per cent of total imports in 1991;GATT 1993: 79).

Estimates of Uruguay Round Effects onMexican Macroeconomic Variables

Effects of Uruguay round liberalization onMexico's welfare (real income), GDP and othermacroeconomic variables have been assessed bymeans of so-called computable general equilib-rium models (CGEs) calibrated and run by theOECD (Goldin et al. 1993). CGEs depart frombase run (status quo) scenarios and simulatescenarios of policy changes, whose net effectsare captured as deviations from the base run.CGEs have been designed to assess the effects ofthe Uruguay round on prices of individual agri-cultural goods and on welfare of sub-regions andindividual countries including Mexico. The lib-eralization scenarios chosen for the simulationswere first a multilateral 30 per cent reduction inall border measures, both in agriculture andnonagriculture including a reduction in agricul-tural input subsidies by the same amount (partialmultilateral liberalization). Alternatively, a sec-ond scenario assumes the multilateral removal ofall distortions in order to illustrate the maximumpotential gains from reform (full multilateralliberalization). Finally, for illustration, the ef-fects of full unilateral liberalization of Mexicowithout reciprocity from other trading partnershave been assessed (full unilateral liberaliza-tion). All three scenarios begin with 1985 asbase year and show liberalization effects as de-viations from the status quo scenario in the year2002.

12

Hence, before discussing the effects of multi-lateral liberalization, it is illustrative to presentthe results of base run scenarios of the CGEs forMexico, i.e., what would happen until 2002 if noliberalization occurred (Goldin et al. 1993:Chapter 4, Table 4.7). The base run suggeststhat

- the rural share of GDP in Mexico would re-main virtually constant (1985:10 per cent;2002:10.6 per cent);

- the rural share of the labour force would de-crease from 33 to 23 per cent due to rural-to-urban migration;

- the rural-urban income parity would rise from22 (a very low level by Latin American stan-dards) to 39 per cent. Such improvement inincome equity would be driven by the increasein the share of agricultural exports in totalexports from 7 to 23 per cent. Behind thisrelative improvement of the rural incomesstands the assumption that Mexico's realwages in the urban sector will become com-pressed, particularly because the compressionof world energy prices is expected, which willaffect Mexico as a net energy exporter.4 Suchcompression will be not as strong in the ruralsector because rural factor prices partlybenefit from a reduction in input costs;

- in spite of increases in the share of agricul-tural imports in total imports from 10 to 26per cent, Mexico is expected to become a netagricultural exporter by 2002.

The results of deviations from this base-runscenario due to Uruguay round liberalizationreflect the typical first-round mechanism ofCGEs and have to be interpreted accordingly.Under the first scenario (partial multilateralliberalization), Mexico would enjoy increases inboth rural and urban value added (Table 5) be-cause overall production increases. Hence, itsGDP rises. Yet, the urban sector would incur adecline in welfare (real income) due to lowerprotection of the manufacturing industry, whichstands for "urban" production. This would meana real devaluation in this sector necessary tomeet the balance of payments constraint. Giventhe much larger share of the urban sector rela-tive to the rural sector in Mexican GDP (9:1 in

1985), such losses would be larger than the in-come gains for the agricultural sector, whoseimplicit taxation would be removed. Incomelosses are mirrored in the deterioration of Mexi-can terms of trade. They stem from increases inimport prices (mainly due to the food sector, asMexico is a net food importer) not compensatedfor by similar export price increases, as oilprices decline. Thus, overall, there are smallurban-sector-driven welfare losses (muchsmaller than for Brazil, for instance) as first-round effects. Second-round effects after realdevaluation in the urban sector are more favour-able but cannot be captured in the models. Theywould bring substantial sectoral shifts in favourfor the export sector, in agricultural goods butprimarily in exportable manufactured products.

Table 5 - CGE-Based Estimates'1 of Effects of DifferentLiberalization Scenarios under the Uruguay Round onKey Macroeconomic Variables of Mexico

Partial multilat-eral liberaliza-tion1'

Full multilateral

Full unilateralliberalization

For comparison:Effects of higher

OECD growth0

Effects of in-crease in nettransfers

Realincome

(welfare)

Ruralvalueadded

Urbanvalueadded

Rural/urban

incomeparity

Foodprices

Terms oftrade

-0.9 0.9 1.4 8.0 5.0 -2.8

1.8 2.9 4.4 20.4 8.3 -3.4

2.5 -0.2 4.7 7.1 0.3 0.1

1.0 -fl.4 -2.0 -2.5 -1.4 -0.1

2.3 -0.4 2.2 -3.5 -1.2 -0.2

aPer cent change in the year 2002 from the base simulation. — Comprisesliberalization in the agricultural and nonagricultural sector. — cIncrease inOECD growth = Growth rates of 4-5 per cent instead of 2-3 per cent. —Increase in net transfers = assumption of increase in net transfers of $3

billion to Mexico, starting in 1993. — Partial liberalization: cut of tariffs,NTB equivalents and input subsidies by 30 per cent. — Full liberalization:full removal of all distortions.

Source: Goldin et al. (1993: Tables 4.8-4.13).

Maximum effects arise from the second sce-nario (full multilateral liberalization), which ofcourse was neither targeted by nor achieved inthe Uruguay round and, hence, is discussed herefor illustrative purposes only. As this scenarioholds for all regions and countries, Mexico isexpected to enjoy an increase in real income that

13

would amount to less than 2 per cent. Comparedwith the other countries and regions (includingBrazil and other Latin America), which wouldgain by 4-10 per cent, the Mexican benefitsfrom full multilateral liberalization appear sur-prisingly small. This "outlier" result reflects thefact that Mexico as an oil exporter will incure anegative terms-of-trade shock due to the ex-pected decline in oil prices after the liberaliza-tion in worldwide manufacturing industries andthe ensuing decline in manufactured goodsprices. The increase in urban GDP by more than4 per cent is remarkably higher under full lib-eralization than in the first scenario and stemsfrom the elimination of unemployment. As in thefirst scenario, the rural sector benefits from ris-ing world market prices and the reduction inimplicit taxation because manufacturing importtariffs are reduced.

The third scenario (full unilateral liberaliza-tion) is helpful to capture effects of Mexico'sstructural adjustment programmes, which in-cluded unilateral liberalization as one of the keyelements (albeit not full liberalization as thescenario implies but only partial). Here, anamazing finding warrants explanation: incomegains for Mexico from unilateral liberalizationare even larger than from full multilateral lib-eralization. This holds first because Mexicowould not face a significant decline in energyprices because world manufacturing goodsprices would not change. Hence, its terms oftrade would remain virtually constant. Second,as a net food importer, Mexico benefits fromunchanged food prices and thus pays for a lowerimport bill than under multilateral liberalization.

Apart from the three liberalization scenarios,the OECD model introduces two alternativescenarios suitable to inject higher growth in theMexican economy. One comprises an autono-mous net inflow of transfers of $3 billion an-nually from 1993 onwards, financed by theOECD countries and the Upper Income Asiaregion. The second one assumes higher growthin OECD countries (by about 1-2 percentagepoints higher than in the base run simulation).Under the first scenario, benefits to Mexico aresizeable but, contrasting to Brazil, appear onlygradually over time with the full effect by 2002.

It is the urban sector that benefits most, particu-larly from the demand effect: while investment isdivided between the two sectors, rural invest-ment leads to increasing demand for urbangoods, whereas urban investment is not expectedto likewise push demand for rural goods. Hence,this scenario would be instrumental to drive awedge in income parities between urban andrural income. The same effect of deterioratingincome distribution would occur under the"higher OECD growth" scenario. In this see-'nario, external demand-driven growth in Mexicowould be only about 1 per cent higher than inthe base run because the simulation assumes nochange in trade distortions in Mexico, whichprevents the country from fully exploiting itscomparative advantages. Following these re-sults, Mexico would not be well advised to relyon a demand pull effect of autonomous highergrowth in the OECD area including the UnitedStates.

Are the estimates plausible? An answer to thisquestion has to take the assumptions into ac-count, hi this respect, two comments are atstake:

First, it is not obvious that the assumption ofconstant terms of trade, and thus declining oilprices, would really hold if multilateral liberali-zation were accomplished. There are other sce-narios likely, too, that would be based on theperception of a fixed link between manufactur-ing prices and energy prices. For instance, risingenergy prices could be demand-driven or politi-cally triggered by energy taxation in OECDcountries, while, at the same time, manufactur-ing prices would rise less because of intensifiedcompetition.

Second, and more important, the CGE modelsbasically capture income effects influenced byterms of trade shifts. They cannot take accountof allocation effects, which are crucial for Mex-ico. Should Mexico really move through a pe-riod of declining oil prices and real devaluation,the following period (second-round) would pushexport growth of both manufactures and someagricultural products and stimulate resources toflow into these sectors. Beyond allocative argu-ments, the main message from the liberalization

14

scenarios focuses on more equitable incomedistribution between the rural and urban sectorand hence on social peace.

Comparing the three liberalization scenariosplus the transfer scenario and the demand pullscenario yields the superiority of liberalizationscenarios for Latin America in general. How-ever, Mexico's case is special because of its oilsector. Because of its role as net oil exporter,changing oil prices have a strong effect on itsterms-of-trade effects (Dutch disease) and thuson its income. Therefore, full multilateral liber-alization triggers real income gains in Mexicobecause removing internal distortions more thanoffsets losses due to declining oil prices. As thisscenario is for illustrative purposes only, unilat-eral liberalization fares best next because it doesnot influence world oil prices in a downwarddirection. The first scenario, which we may callthe Uruguay round scenario, does not seemoverly appealing for Mexico because it bringsterms of trade losses following declining oilprices as well as income losses for the dominanturban sector suffering from real devaluation.

2. Investment Perspectives

a. Domestic Resource Mobilization andAllocation

How much of the gross product is invested in-stead of consumed and how productive investedfunds are, decides on economic growth. Both thepublic and the private sector invest and short-term effects of private investment on growth areoften found to be higher than those of the publicsector (Khan and Reinhart 1990). Yet, it islikewise evident that a minimum amount of pub-lic investment in inf astructure is needed to intro-duce productive private investment. Further-more, distinction has to be made between in-vestment in physical and human capital, and, asfar as the contribution of human capital to

growth can be empirically isolated from thephysical capital, the effects of human capital oneconomic growth in developing countries arefound to be very significant (Gundlach 1995). hiaddition, the source of financing investment hasto be taken into consideration.

Gross Domestic Capital Formation and CapitalProductivity in Mexico

Mexico's investment record has not been im-pressive so far if it is compared with the Asianfirst and second generation of emerging coun-tries. Even if top outliers like Singapore (aver-age investment ratio 1970-1989: 39 per cent)and Korea (28 per cent) are refused as the rele-vant yardstick for Mexico, also other middle-income Asian countries invested more thanMexico (1970-1989: 20. 4 per cent).5 Onecould assume that the liberalization period after1985 encouraged economic agents to investmore but the development of investment ratiosafter 1983 does not support this assumption(Table 6). Private investment ratios in Mexicoclimbed by about three percentage points up to apeak level of 16 per cent in 1993, but this waspartly offset by a decline of public investmentratios by 2 percentage points. The investmentrecord of five other middle-income countriesshows higher average levels (except for Argen-tina, which seems at par with Mexico) and morechange over time. Apart from Malaysia andThailand with their high investment levels, theupward changes in Chilean investment ratiosappear most remarkable and mirror the appro-priate reaction of investors to consistent adjust-ment efforts. Interestingly, public investmentratios in the rapidly growing Asian countrieswere always much higher than in Mexico. Thissupports the view that public investment thatdoes not crowd out private agents plays animportant role for productivity gains achievedby private investment and probably exerts agenuine influence on medium-term growth.

15

Table 6 — Private and Public Investment in Mexico and Selected Developing Countries, 1983—1993 (in per cent)

Mexico

35

30

25

20

15

10

5

Chile

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Argentina Indonesia

35

30

25

20

15

10

35

30

25

20

15

10

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Malaysia Thailand

35

30

25

20

15

10

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Private Public

Source: Glen and Sumlinski (1995).

35

30

25

20

15

10

5

1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993

Besides investment volumes, the productivityof investment determines economic growth. Un-derstandably, productivity is difficult to measurebecause data on capital stock and depreciationrates are required which are usually not avail-able. A macroeconomic proxy is the reciprocalof the relation between cumulative investment ina period and increments of GDP, the so-calledincremental capital/output ratio (ICOR). Similarto the investment ratios, productivity measuresthat are based on World Bank estimates do not

place Mexico in a top-score position comparedwith most Asian countries (except the Philip-pines) in the 1980-1991 period (Table 7). Giventhe shortcomings of the measure, one should becautious to derive far-reaching conclusions con-cerning its absolute magnitude. Yet, as short-comings are probably systematic, an inter-coun-try comparison is still possible. Such a compari-son suggests that in the past Mexico did notmake full use of its invested funds. One reasonmay be that real appreciation made domestic

16

technologies obsolete and that the full replace-ment of these technologies by a new capitalstock could not be achieved because Mexicolacked access to medium-term financial re-sources, both internally and externally.

Table 7 - Marginal Capital Productivity3 in Mexico andReference Countries, 1980-1991

Mexico 0.078Chile 0.200Brazil 0.056Argentina -0.042Colombia 0.172aPeriod averages: Recipnxput ratios defined as the sment over the period divicthe GDP at the end and the

Malaysia 0.200Indonesia 0.213Philippines 0.057Thailand 0.294Korea, Republic of 0.313

:al of incremental capital out-um of gross domestic invest-ed by the difference between; beginning of the period.

Source: World Bank (1992).

Financing Capital Formation throughDomestic Savings

Until the mid-eighties, Mexico had a ratio ofgross domestic savings to GDP that rangedabove the Latin American average but fell shortof ratios achieved by Asian countries; between1973 and 1987, average Mexican gross domes-tic savings amounted to 21 per cent. Measuredagainst the gross domestic investment of 23-24per cent, financing by external savings amountedto 3.7 per cent of GDP in 1973-1980 and 1.3per cent in 1980-1987 (World Bank 1989: 153).hi comparison, other major Latin Americancountries financed the larger part of their in-vestment by external savings.

One of the major differences between Asiancountries and Mexico, which may explain highersavings mobilization in Asian countries is thatthey enjoyed positive real interest rates, whileMexico throughout the entire period had highlynegative rates below -5 per cent (World Bank1989: 39). Hence, savings mobilization wasstrongly discouraged in Mexico. After 1991,when real appreciation of the peso fuelled importdemand in consumer durables, the need to fi-nance domestic investment externally rose be-cause private households saved less. Privatedomestic savings fell until 1993 when access toconsumer credits was tightened. Under theseconditions, foreign capital inflows contributed to

finance an inrease in domestic consumption,particularly in durables. Such coincidence ofgrowing current account deficit and decliningprivate savings provoked fears that Mexicowould face difficulties to generate foreign ex-change to service debt (World Bank 1994: 331).Fears culminated in 1994 and exposed a particu-larly risky element in Mexico's external financ-ing, due to the maturity structure of inflows.

b. Structure of Capital Inflows

During the 1980s, Mexico's current accountdeficit remained moderate in the range of 1 percent of GDP. Compared with all low-income andmiddle-income countries (1.4 per cent), this wasa very low level. Between 1991 and 1994, how-ever, the current account deficit has virtuallyexploded from 6.5 per cent in 1991-1993 to 8.2per cent in 1994 (World Bank 1995: 81). Thisrise was the result of an unprecedented change inthe sectoral composition of inflows, a changefrom long-term financing through foreign in-vestment to shorter-term financing through port-folio investment, hi 1988, the portfolio invest-ment amounted to only 6 per cent of FDI inflowsin Mexico. Between 1988 and 1993, the ratiorose steadily from 11 per cent in 1989, 255 percent in 1991, 436 per cent in 1992 and 568 percent in 1993. The trend was broken in the firstquarter of 1994, when portfolio inflows began todecline sharply. Second-quarter portfolio in-vestment amounted to only 14 per cent of first-quarter inflows,6 and short-term dollar denomi-nated debt became a very important factor infinancing the current account deficit.

It is important to note that neither the speed ofthe shift nor the shift itself was unique to Mex-ico. Despite wide differences in macroeconomicpolicies and economic performance betweenLatin American countries, most countries be-came subject to portfolio investment inflows.Yet, Mexico received almost three-quarters ofthe portfolio investment of all Latin Americancountries by 1991 and more than 80 per cent in1993. Similarly to Mexico, capital inflows in theother countries of destination were accompaniedby appreciation of the real exchange rate,booming markets for nontradables such as real

17

estate, bullish stock markets, an accumulation offoreign reserves and a more optimistic assess-ment of the debt overhang situation as shown bythe increase in secondary market prices for for-eign loans. Yet, from the very beginning, fearscirculated that some of the inflows were of thehot money variety and would be reversed onshort notice, thus sparking a domestic financialcrisis. Such reversals were feared to becomevery strong — and they indeed materialized inlate 1994 — in a situation in which internalinconsistencies and assessments of unsustain-ability of macroeconomic conditions in the hostcountries coincided with external pull factors,such as increases in real interest rates in inter-national capital markets or liberalization of port-folio markets in other potential host countries.7

To delink from such validity, it is of utmostimportance that Mexico attracts FDI which doesnot only reflect a change in ownership but fi-nances additional capital formation in a sustain-able way. This is why special attention is to bepaid to Mexico's attractiveness for foreign in-vestors in competition with other potential hosts.

c. Attractiveness for Foreign DirectInvestment

In the last few years Mexico's current accountdeficit became increasingly financed by portfolioinvestment while the share covered by FDI de-clined. However, this is not to say that Mexicowas unsuccessful in attracting more FDI in theearly 1990s than before. A three years averageof FDI annual inflows during 1991-1993 com-pared with 1988-1990 yields an almost doublingof FDI inflows. This rise continued until the firsthalf of 1994.8 However, given that FDI flows tomany Asian and also Latin American countrieshas risen to unprecedented level since 1990 (BIZ1994: 102), Mexico's record must not necessar-ily be outstanding. To put absolute increases inFDI flows to Mexico into perspective, it is help-ful to have a closer look at the regional distribu-tion of major home countries' FDI in order toanalyse whether or not Mexico improved its po-sition as a host relative to other hosts. Therefore,in the following, three major home countries'investment stocks in Mexico are analysed rela-

tive to the development of these countries' FDIworldwide: the United States, Germany andJapan.9

Mexico's Position in US FDI

According to SECOFI, the Mexican Secretaryof Commerce and Industrial Development, theUnited States accounted for almost 62 per centof total cumulative FDI in Mexico in 1992, fol-lowed by the United Kingdom (6.5 per cent) andGermany (5.8 per cent). Switzerland, Japan,France and Spain ranged next (Deutsch-Mexika-nische Industrie- und Handelskammer 1992).Therefore, the attractiveness of Mexico for USFDI is of outstanding importance for the generallocational competitiveness of Mexico. Table 8provides a breakdown of the Mexican share inUS worldwide FDI by industries from 1980(before the debt crisis) to 1993. The followingfindings emerge:

- For all industries, Mexico's share in US FDIis U-curve-shaped. It declined during the pe-riod of crisis and adjustment, had a turningpoint by 1988 and rose until 1993. Yet, therewas no additional gain in share. Mexico re-gained what it had lost and stood exactly atthe same level in 1993 as in 1980: it ac-counted for 2.8 per cent of US FDI.

- Sectorally, there were different shifts betweenmanufacturing and nonmanufacturing, basi-cally services. Mexico became slightly moreattractive as a host in manufacturing (1980:5.1 per cent, 1993: 5.4 per cent with theslump in 1987/88) but lost in service indus-tries. Investment in the oil sector remainedmarginal due to access restrictions.

- The food industry, which showed the onlydouble-digit share in 1993, and, to a lesser ex-tent, the motor vehicle industry (transportequipment), were positive outliers because theupswing in their U-curve was greater than thedecline.

- Industries in which Mexico lost in attractive-ness regardless of the swing are primary andfabricated metals and also electric and elec-tronic equipment. Losses in the primary andfabricated metals may be natural and lesstroublesome because this is a less skill-inten-

18

Table 8 - Share of Mexico in Total US FDI Stock by Sectors and Industries, 1980,1985-1993 (in per cent)

1980198519861987198819891990199119921993

All in-dustxics

2.82.21.81.61.72.22.42.72.72.8

Petroleum

030.10.10.10.10.1n.a.n.a.n.a.n.a.

Manufacturing

total

5.1433.63.03.4434.64.95.05.4

food andkindredproducts

4.54.83.91.72.15.2117.773

103

chemicaland alliedproducts

5.53.73.43.44.045454.64.45.2

primaryand

fabricatedmetals

8.16.43.63.42.93.73235n.a.n.a.

machinery.except

electrical

2.41.00.7030.61.81.71.7n.a.n.a.

electric andelectronicequipment

5.85.2433.63.5n.a.4.43.83.633

transportequipment

6.07.06.95.45.97.48.49.69.98.5

othermanu-

facturing

5.15.1423.94.4n.a.4.34.44.75.2

Whole-saleHade

2.82.4130.81.01.31.31.51.51.4

Banking

n.a.0

n.a.n.a.n.a.n.a.n.a.n.a.n.a.n.a.

finance(except

banking),insuranceand realestate

0.60.80.50.40n.a.0.60.60.60.6

Services

_ .

n.a.02.71.92.02.42.22.12.11.7

Other in-dustries

n.a.

2.1n.a.n.a.n.a.3.14.87.48.07.9

Source: US Department of Commerce (various issues).

sive industry that is declining in US totalmanufacturing FDI. Countries with a lowerincome than Mexico have improved their lo-cational competitiveness. The decline in elec-tric and electronic equipment should givemore rise to concern. This is an industry witha rising share in total US manufacturing FDIand with increasing amounts of funds investedin Asian countries. Some of them might focuson purely labour-intensive activities with fewskill requirements but other parts might ab-sorb more human capital and, hence, shouldbe important for improving Mexico's "tech-nological base".

Overall, until 1993, Mexico did not yet madeoutstanding progress in attracting much moreUS FDI in competition with other hosts than itlost before. However, completing NAFTA willstill provide much scope for gains in attractive-ness.

Mexico's Position in German FDI

As in the United States, Mexico's share inGerman total FDI declined from the peak levelbefore the debt crisis until 1987, and has recov-ered partially since then. However, with 1.2 percent of total FDI compared with 1.6 per cent in1981, there was no full recovery as in the UnitedStates (Table 9). The Mexican motor vehicleindustry proved to be the most important targetfor both German and US companies, but thisindustry failed to attract the same share of totalGerman FDI that it had before the debt crisis,when Mexico accounted for almost 10 per cent

of total German foreign investment in this indus-try. Two other industries, chemicals and electri-cal machinery, did better in terms of exceedingthe pre-debt crisis level. These industriesreached a share of 2-3 per cent each but thisshare remained much lower than for investmentin the motor vehicle industry. Investment in foodindustries, which proved to be the most attrac-tive industry for US investment, did not play anysignificant role in German FDI.

To put the overall level of German investmentin Mexico (little more than 1 per cent) in a rightperspective, one has to bear in mind that Ger-man FDI in general mirrors a clear bias towardinvestment in OECD countries. Such bias canneither be observed in the United States nor inother OECD countries. In 1992, only 9.5 percent of total German FDI stock accrued to in-vestment in developing countries (including theOPEC countries and the emerging East andSoutheast Asian countries but excluding China).US investment outside the OECD countries, forinstance, amounted to more than 30 per cent. IfMexico's attractiveness is assessed only in com-parison with FDI in other developing countries,Mexico's share in German FDI scores substan-tially better than in US investment (13 per centcompared with only 9 per cent).

Nevertheless, German investment in Mexicohas lacked dynamism in recent years. Since1989, when the post-adjustment period began,Mexico's share in German FDI has remainedstagnant. Neither the NAFTA foundation nor thesubstantial efforts in domestic adjustment suc-cess could trigger more German investment in

19

Table 9 - Share of Mexico in Total German FDI Stock, by Sectors and Industries, 1981-1993

19811982198519861987198819891990199119921993

Allindustries

1.60.60.70.60.81.31.21.21.21.21.3

Mining

n.a.n.a.n.a.______

-

Manufacturingtotal

3.21.11.41.21.62.82.42.72.72.73.1

chemicalindustry

, 2.80.81.71.52.83.33.13.22.93.13.3

iron andsteel

0.90.31.51.2_

0

n.a.n.a.n.a.

machinery

0.60.20.60.50.40.50.40.40.40.40.5

transportequipment

9.63.22.01.61.97.06.17.06.95.67.4

electricalmachinery

2.00.71.21.10.81.31.61.81.92.42.9

Trade

0.30.20.1000.20.30.30.30.30.4

Banking

_—

__

__000

Other

industries

0.30.30.1000000.20.20.2

Source: Deutsche Bundesbank Die Kapitalverflechtung der Untemehmen mit dem Ausland nach Landern und Wirtschafis-zweigen (April 1989-April 1992), Deutsche Bundesbank Kapitalverflechtung mit demAusland (May 1994, May 1995).

Mexico than in other host countries. Recent FDIflow figures for 1993 and 1994 do not display amore encouraging result. In 1993, net flows ofGerman FDI to Mexico amounted to DM 2 mil-lion only (including an net outflow of reinvestedprofits from Mexico of DM 50 million), while in1994 net flows to Mexico comprised DM 163million or 10 per cent of net flows to all develop-ing countries (0.6 per cent of total German netFDI flows abroad) (Deutsche Bundesbank 1995:46). Given the rapid increase in German FDIflows in general and to individual countries inparticular (for instance, European transforma-tion countries and China), this disenchanting de-velopment in fact is a challenge to Mexico's lo-cational competitiveness.

Mexico's Position in Japanese FDI

Mexico's position in Japanese FDI deviatesstrongly from its position in US and GermanFDI in a negative direction. Slight absolute in-creases cannot obscure the fact that only 0.5 percent of the total stock of approved Japanese FDIaccrued to Mexico at end March 1994 (accumu-lated fiscal years 1951-1993) (Japan, Juneissues).10 In addition to the very low level, it isthe trend that causes concern. Since 1985, whenMexico achieved to attract a share of 1.6 percent of the Japanese FDI stock, the trend hassteadily been negative, in spite of the Mexicanrecovery in the second half of the eighties. Be-tween 1985 and 1995, the trend in Japaneseinvestment in the United States was rising (from30.2 to 41.9 per cent). This signals that neither

Mexican GATT entry nor the foundation ofNAFTA and the adjustment efforts could induceJapanese companies to invest at the low-incomeperiphery of NAFTA.

As this trend runs against those observed forUS and German investment showing either fullor partial recovery from the shock of the debtcrisis, there is reason to assume specific charac-teristics of Japanese investment pattern. Onereason could be the relatively high share of in-vestment in nonmanufacturing industries pre-ferred by Japanese companies (primary sectorplus real estate and other services). As long asthese sectors were closed to nonresidents inMexico, FDI was refrained from entering theMexican market. The second aspect, likely to bemore important, could be the relatively high skillrequirements of Japanese investment in sophisti-cated industries, which could be more easily metin the United States than in Mexico. Whateverreasons a detailed analysis of motives of Japa-nese investors would display, it remains a chal-lenging experience for Mexico to see rising partsof Japanese investment bypassing the country,while the amount of Japanese worldwide invest-ment has risen by more than 20 per cent annu-ally since 1985.

3. Policy Recommendations

The investigations into trade and investmentperspectives suggest the following recommenda-tions:

20

(1) hi future, unilateral trade policy reformsin Mexico should be targeted to reduce still ex-isting discrimination between sectors and, withinthe manufacturing sector, between industries.Given past achievements in trade liberalization,neutrality in incentives through a uniform pro-tection level now appears more important thanfurther liberalization across the board. Thiswould also help to diversify the existing patternof exports.

(2) Developing the potential of the rural sec-tor should receive more attention. The rise inworld market agricultural prices that will followthe implementation of the Uruguay round willprovide additional incentives. It is known frommany countries that the productivity potential inthe rural sector is vast and can be mobilizedwithout large amounts of capital inflows.

(3) Mexican exports outside the primary sec-tor are strongly concentrated on US demand forconsumer durables. To lower the dependence onUS business cycles in general and on interestrates for consumer loans in the United States inparticular, regional and sectoral diversificationof exports should be envisaged. Asian andEuropean markets are prime candidates for bothsourcing and export outlays. Sectorally, agricul-tural products and products from capital andintermediate goods industries would be condu-cive to broadening the export base.

(4) Relatively low investment productivity inthe past has been one of the weaknesses ofMexico's growth path. To shape this unsatisfac-tory result, it is necessary to channel future in-vestment funds more into sectors that generateor save foreign exchange earnings. It cannot beexcluded that the boom period fuelled investmentin inward-oriented activities, which absorbedforeign exchange on a net basis rather than gen-erating i t

(5) Past FDI inflows from the United States,Germany, Japan, and the United Kingdom donot reveal that investors could be convinced toprefinance a medium-term improvement ofMexico's locational competitiveness due toNAFTA and other institutional commitments.To anchor Mexico as an attractive host in loca-tional decisions of investors, concerted actions

of established companies, trading houses, banksand institutional investors seem appropriate.Preferably, such actions should concentrate onpotential investors in Asia and Europe, hi thisrespect, perspectives of a new EU concept foreconomic relations with Latin America (includ-ing plans of a bilateral free trade agreement be-tween the EU and Mexico) may stimulate tradeand investment flows, provided that the effectsof easier access to EU markets are not jeopard-ized by adverse supply-side conditions in Mex-ico.

(6) Mexico has proven to be a relatively suc-cessful exporter of nonfactor services. As suchservices are one of the most rapidly growingsegments of world trade, it is important to fur-ther improve Mexico's competitiveness in serv-ices. For this purpose, it is helpful to identifybroad categories of Mexico's exports of services(for instance, consumer services (travel, passen-ger transport), trade-related services (merchan-dise transport), financial services and other busi-ness services) and their determinants in order tostrengthen the export base.

(7) The experiences of Asian NICs suggestthat early outward orientation of domestic capi-tal helps to secure access to export markets, hithis respect, Mexican investment abroad (outsidethe United States) is still relatively small11 andoffers scope for extension.

Finally, macroeconomic stability is necessarybut not sufficient if Mexico is to exploite itslong-term potential. It is the competitiveness ofMexico's immobile factors of production (itsunskilled labour, its regulatory system, its infra-structure) that will decide whether or not Mexicocan successfully compete for mobile resources inthe world economy, hi addition to domesticpolicies, assistance can be provided throughOECD membership, which contributes tomacroeconomic and institutional guidance. Fur-thermore, important trading partners as the EUwill contribute to Mexico's welfare if they rec-ognize that more institutionalized relations withMexico are helpful to lower costs of informationand uncertainty and thus to stabilize expecta-tions on Mexico's future development.

21

III. Short-Run Distortions: The Monetary Side

1. The Failure of Exchange-Rate-Based Stabilization

From 1988 to December 1994, the Mexicanexchange rate policy went through three mainphases.12 First, after an initial devaluation of38.9 per cent, the peso/dollar rate was fixed.Second, the authorities shifted toward increasedflexibility by adopting a pre-announced crawlingpeg after January 1989: the peso/dollar rate wasallowed to depreciate by 1 (old) peso13 per dayin 1989, 80 cents per day in 1990, 40 cents perday in 1991, and 20 cents per day in 1992 untilOctober, when the speed of the crawl was in-creased again to 40 cents per day. Third, anexchange rate band was adopted in November1991. This band differed from those of othercountries like Israel and Chile14 in several re-spects:

- While the band's ceiling was subject to adaily pre-announced depreciation by a fixedamount, the band's floor remained fixed.Consequently, the width of the band was in-creasing with time.

- The rate of crawl of the band's upper limitwas specified in nominal terms, a fixedamount of cents per day, rather than in percents.

- There was no official announcement of a cen-tral parity. Only the band's upper and lowerlimits were officially announced. The authori-ties also announced every day before tradingbegan their narrow band target range for thatday. In practice, interventions inside the bandwere the rule rather than the exception, andthe exchange rate stayed near the middle ofthe band most of the time.

Notwithstanding these special features, theMexican exchange rate policy and the relatedmacroeconomic reforms laid down in the Pactoagreements15 fall in the category of exchange-rate-based stabilization attempts. The basic ar-gument for such a stabilization policy is that anominal anchor in the form of a fixed exchangerate or a pre-announced rate of depreciation,

lower than the difference of inflation at homeand abroad (active crawl), imports the anti-inflationary reputation of a foreign currency bytying the hands of the own monetary authorities.If discretionary policy is ruled out and monetarypolicy is determined by the foreign central bank,the credibility of the reform will improve, pri-vate agents will adjust at once, and inflation willdecrease to the level of the stable currency(Schweickert 1994a). However, the experiencethat developing countries made with exchange-rate-based stabilization is in sharp contrast withthe appearing features of the theoretical concept:an expansionary first phase was typically endedby a balance-of-payments crisis (Schweickert etal. 1992).16

The question is whether the concept or an in-consistent implementation is to be blamed for thefailure of exchange-rate-based stabilization inMexico. This question is not only relevant foracademic but especially for practical reasons.The trade and investment perspectives outlinedin Chapter II crucially depend on a stablemacroeconomic framework, i.e., a macroeco-nomic policy that provides a noninflationary en-vironment (stabilization) and a stable develop-ment of the real exchange rate close to its equi-librium (structural adjustment). These two tar-gets are presently at risk and the role that thepast exchange rate policy played in this devel-opment is to be identified in order to determinesolutions for the future that allow the trade andinvestment potential to be realized.

a. Stabilization versus StructuralAdjustment

A look at the development of macroeconomicindicators summarized in Table 10 reveals thatMexico repeated the "traditional" pattern ofexchange-rate-based stabilization programmes.The real exchange rate appreciated because thenominal devaluation was kept low, while infla-tion inertia was quite substantial. Two explana-tions can be offered. First, wage increases were— with the exception of 1988 — significantly

22

Table 10 - Exchange-Rate-Based Stabilization in Mexico: Macroeconomic Indicators,

Nominal exchange rate (NEX)a

peso:dollarConsumer prices in Mexico

(CPMEX)Consumer prices in the United

States (CPUS)Real exchange rate (CPMEX-

CPUS-NEX)b

Wages in Mexico (WAMEX)Wages in the United States (WAUS)Relative wages (WAMEX- WAUS-

NEX)GDP, real

Trade balanceCapital accountDirect investmentPortfolio investmentOther capital

Net foreign assetsMoney (Ml)

Overall fiscal balancePrimary fiscal balance

1988

3.2

114.3

4.0

107.1112.2

2.8

106.21.2

1,668-5,871

635121

-£,627

-72.267.8

-10.78.0

1989

15.8

20.1

4.9

-0.633.72.9

15.03.3

-645973

2,648298

-1,973

13.837.3

-4.97.9

1990 1991

1988-1994

1992

percentage change during the perioc

11.5

26.5

5.4

9.630.5

3.3

15.74.5

4.3

22.7

4.2

14.229.1

3.3

21.53.6

1.4

15.5

3.1

11.017.52.4

13.72.8

millions of dollars

-4,4338,4402,548

-3,9859,877

-11,32925,1394,742

12,1388,259

-20,67727,0084,393

19,1753,440

1993

I

-0.3

10.0

2.8

7.58.62.6

6.30.6

-18,89132,0594,901

27,867-709

percentage change during the period

33.663.1

142.8123.9

30.415.1

per cent of GDP

-2.87.3

-0.55.0

1.65.8

a - : appreciation. — -: depreciation. — °EIU estimate. — "First half. — eFirst three quarters.

56.317.7

0.73.9

1994

71.4

7.0

2.5

-66.98.62.7

-65.53.1C

- l l ,477 d

13,207d

3,321d

8,811d

l,075d

-36.0e

-8.9

0.02.6

Source: IMF International Financial Statistics (various issues), IMF IMF Survey (6 February 1995), EIU Country ProfileMexico (1993/94), EIU Country Report Mexico (1st quarter 1995), own calculations.

higher than consumer price increases, allowingcosts to push. Second, monetary expansion wasdriven by the inflow of foreign exchange due tothe dramatic increase in capital inflows, allow-ing demand to pull. The expansionary effect ofcapital inflows translated into positive realgrowth rates and, together with the real appre-ciation, produced a large trade deficit, whichreached 5.2 per cent of GDP in 1994 (currentaccount deficit: 8.2 per cent).17

Generally, the internal and external equilib-rium of the Mexican economy became more andmore dependent on the sustainability of capitalinflows and — as Table 10 shows — especiallyon the sustainability of foreign portfolio invest-ment Portfolio investment, however, is a mixedbag with respect to its stability (Reisen 1995).Investment by pension funds and life insurance

companies can be taken as long-term investment,since these funds follow a buy-and-hold strategyrather than a trading strategy in the emergingstock markets. Unlike banks and most otherinvestors, pension funds and life insurance com-panies benefit from regular inflows of funds on acontractual basis and from long-term liabilities(with no premature withdraws of funds). To thecontrary, equity-related investment by domesticresidents with overseas holdings, by privateforeign investors and from managed funds(country funds and mutual funds) are largelygoverned by cyclical determinants and orientedat short-term returns. In the course of the early1990s, the decline in returns on riskless assets inthe United States and the OECD countriesbrought much speculative money to the emerg-ing stock markets. What is more, with the need

23

to have sufficient cash to pay off clients redeem-ing their holdings, a widespread crisis forcesfund managers to sell in markets totally unre-lated to the origin of the crisis.

Limiting the flexibility of the nominal ex-change rate also intensifies the risk related toother capital flows. If the exchange rate systemis credible, foreign investors can earn signifi-cantly higher interest rates than at home, whiletheir risk is limited by interventions of the do-mestic monetary authorities in order to containthe nominal exchange rate within its band. InMexico, this has led to an ex-post interest rate tobe earned on Mexican deposits by Americaninvestors that was about 12.5 percentage pointshigher than the interest rate on American depos-its. This helped to pull speculative, short-termcapital into Mexico.

The riskiness of Mexico's external positionmaterialized during 1994. The regional upheav-als and the elections, together with some uncer-tainty about the possibility to refinance short-term government debt, created sufficient uncer-tainty for portfolio and other capital flows tochange their direction, and the real exchange ratebecame overvalued.18 This demonstrates that therisk related to an exchange-rate-based stabiliza-tion programme is rather due to the concept. Ifcapital flows out, as was the case in 1988, whenthe peso/dollar rate was fixed, the programme isended because a monetary contraction should beavoided. If capital flows in, as has been the casesince 1989, monetary expansion slows downinflation convergence and, hence, speeds up realappreciation leading to a large trade gap, whichmakes a "soft landing" increasingly difficult.

This is not to say, that there have been nocomponents of the Mexican economic policythat can be criticized because alternative policiesmay have helped to speed up inflation conver-gence. Before proceeding to this discussion, ageneral statement is in order. It is relatively easyto identify such inconsistencies ex post, and it isvery likely that without the political disturbancesof 1994 foreign investors and economists wouldstill live very comfortably with the Mexicanreform model. The following discussion is never-theless important for identifying optimal futureexchange rate strategies.

b. Complementary Policy Measures

Monetary and Exchange Rate Policy

The type of exchange-rate-based stabilizationimplemented in Mexico allowed two degrees offreedom with respect to the conduct of macro-economic policy: (i) the rate of the crawl of thenominal exchange rate could be adjusted, and(ii) money supply could be manipulated via thedomestic component of the money base. Overthe period 1988-1994 the use of both instru-ments shows considerable volatility.

Most of the real appreciation during the pe-riod took place in 1988, when the rate of thecrawl was zero and monetary policy was ex-pansionary although net losses of foreign assetswere significant (Table 10). This was clearly aninconsistent policy given the priority of the sta-bilization target. The concept of exchange-rate-based stabilization would have required thatmonetary contraction forces inflation down asquickly as possible in order to meet the stabiliza-tion target and in order not to let a dramatic realappreciation disturb structural adjustment.

The correction of this policy, which tookplace in 1989, went into the right direction: therate of the crawl was increased to 1 peso per dayand monetary policy was tightened. This policyresulted in a passive crawling peg, i.e., the dif-ferential between Mexican and US inflation wascompensated by the nominal devaluation and thereal exchange rate was kept constant with atrade deficit of negligible amount and a realgrowth rate of 3.3 per cent (Table 10). Hence,the Mexican economy had been in internal andexternal equilibrium at that time, and it is rea-sonable to argue — by hindsight — that thispolicy mix would have provided a stable macro-economic framework. However, Mexicanmacroeconomic policy changed course again in1990, leading to its central flaw, i.e., the exces-sive use of the exchange rate as a nominal an-chor (Bergsten and Cline 1995): while the rateof crawl was lowered, monetary policy becamemore expansionist again, starting a new round ofincreasing inflation and real appreciation.

With respect to monetary policy, there was atleast a chance to be more restrictive (Brand andR6"hm 1995). With the exception of the years

24

1992 and 1993 and to some extent also of 1991,monetary policy tried to sterilize reserve out-flows but not reserve inflows, thus increasinginflation pressures. This can be seen when com-paring the development of net foreign assets andof money supply Ml (Table 10). It implies thatthe fluctuations of money supply were not com-pletely unavoidable as would have been the casein a currency board regime (see the discussion ofthe Argentine case below) but were to someextent produced by an active monetary policythat changed course several times and was notstrictly oriented at keeping monetary expansionas low as possible in order to force inflationdown as fast as possible.19

Fiscal Consolidation

Fiscal consolidation is a cornerstone for estab-lishing the credibility of an exchange-rate-basedstabilization programme. It is necessary to allowthe monetary policy to be determined by theexchange rate target, and it convinces foreigninvestors that their funds are not allocated —either directly or indirectly — into the publicpockets. The Mexican reform efforts in thisrespect were clearly outstanding (OECD 1992).From 1988 onwards, the financial deficit de-clined rapidly until the gap was closed in 1991,largely on account of a steady decline in theexpenditure to GDP ratio, which in 1991 was 15percentage points below that of 1982, while therevenue ratio even declined.

Between 1988 and 1993, the revenue ratiocontinued its downward trend, which was theresult of a tax reform that rather focused on thesimplification of the tax system and on lower taxrates than on increasing fiscal revenue:

(1) The corporate tax base has been rational-ized through full inflation indexation, the systemof multiple corporate tax rates, ranging from 5to 42 per cent, has been replaced by a uniformrate of 35 per cent, the same rate as that chargedon capital gains. Only the real portion of interestpayments (receipts) has been made deductible(taxable). The inflation adjustment of deprecia-tion and inventories variations has also beensimplified and made automatic. Additionally, theexemption of agricultural and transport sectors

from corporate taxation has been ended and aminimum corporate income tax established.

(2) The number of personal income taxbrackets has been reduced from twelve to eight,and the top rate has been lowered to 35 per cent,thus equalizing marginal corporate and top per-sonal income tax rates and consequently reduc-ing the scope for tax arbitrage. The bracketshave been indexed to inflation. Interest incomeof individual residents has been made subject toa withholding tax of 1.4 per cent of the underly-ing principal. However, the extensive list of tax-exempt income components has remained onekey feature of the personal income tax system.

(3) Efforts have also been made to increasethe efficiency of VAT taxation. The standardrate was reduced to 10 per cent in 1991 as partof the government's anti-inflationary incomespolicy. The special rate in border regions hasbeen replaced by the standard rate, leaving food-stuffs as the only exemption favoured by a zerorate. VAT collection has been improved bytransferring its administration from states to thefederal government, which uses banks to collectthe tax.

Although this surely constitutes a straightfor-ward fiscal reform programme, the developmentof the structure of government revenue and ex-penditure reveals two unfavourable trends be-tween 1988 and 1993 that are worth to mention:

(1) Revenue from VAT showed a negativetrend. Contrary to other Latin American reformcountries like Argentina and Chile (Burgess andStern 1993: Table 3.1, Schweickert 1994a),indirect taxation obviously did not enjoy a highpriority in Mexican tax policy. The advantage ofthe VAT is that it discriminates against con-sumption expenditure, an effect that can dampenthe typical consumption boom to be observed inall exchange-rate-based stabilization pro-grammes and, hence, to foster domestic savingsand investment. Additionally, ample evidencewith tax reforms in developing countries showsthat the short-term revenue effect of a tax reformcan be maximized by focusing on indirect taxa-tion (Schweickert 1995a).

(2) While current expenditure increased from5.6 to 9.8 per cent of GDP, capital expenditure

25

declined from 3.6 to 2.7 per cent of GDP. Onthe one hand, this reflects the ongoing privatiza-tion process, which shifts public investment intothe private sector. On the other hand, it can atleast be questioned whether it is appropriate fora country like Mexico to reduce public invest-ment to OECD levels (OECD 1992) rather thanfinancing meaningful investment in infrastruc-ture and public services in order to improve theprospects for catching up.20

Financial Market Policies

A well-developed and efficient financial systemhelps to ease structural adjustment problemsbecause it provides the financial resources torestructure domestic supply when relative priceschange. This is of special importance if ex-change rate flexibility is limited. If the real ex-change rate appreciates, as is typically the casein the first phase of exchange-rate-based stabili-zation, efficiency-enhancing investment in ex-portable or import substitutes provides a stablesource of foreign exchange inflows substitutingfor temporary capital inflows in a later phase ofthe programme, i.e., the supply response substi-tutes for a real devaluation.

The past few years have brought fundamentalchange to the Mexican financial sector (EIU, a1994/95). Apart from liberalizing interest ratesand credit terms and eliminating obligatorylending to the public sector, new financial in-struments and new financial institutions havebeen created. It has been estimated that at theend of 1994 there were around 50 commercialbanks in operation compared with just 19 twoyears earlier, hi 1993, after authorization wasgiven for the establishment of new domesticbanks the total number went up to 30 and in1994 the government granted licenses to sub-sidiaries of banks operating in the United Statesand Canada. There has also been a significantincrease in the number of other financial entitiessince 1988.

Thus, Mexico's financial system has beenstrengthened by its liberalization and deepening.Major contributing factors of this strengtheningwere the privatization of much of the financialsystem and the establishment of a more inde-

pendent central bank.21 Yet, there is still roomfor improvement:22

(1) Mexico's financial sector is still smallcompared with East Asian countries (Korea,Malaysia, Singapore, and Thailand) and otherNAFTA countries. While market capitalizationof Mexican financial institutions is about 60 percent of these countries, the assets as per cent ofGDP are only 44 per cent (26 per cent) fordeposit money institutions and 23 per cent (11per cent) for private nonbank finance companiesof the asset ratio of the corresponding Asian(American) institutions.

(2) The costs of debt and equity finance arevery high for most firms. Bank's prime borrow-ers paid real interest rates of almost 18 per cent,while small and medium-size firms paid over 25per cent at the end of 1993. Among the reasonsfor such high rates are high bank operating costsand insufficient competitive pressure on finan-cial intermediation margins.

(3) Although the newly privatized commercialbanks have managed to build up their capitalbases to meet Basle requirements, they havebeen similarly plagued by bad debts (addi-tionally contributing to the high lending rates).By mid-1994, bad debts on their books wereequivalent to no less than 96 per cent of paid-upcapital and were proving to be an obstacle tonew lending.

(4) The government has greatly strengthenedthe system of prudential supervision. This is im-portant because in the past no bank failure wasallowed. But the complex structure of the finan-cial conglomerates that predominantly providethe financial services in Mexico makes oversightand monitoring a difficult task. Efficient super-vision also suffers from the existence of five fi-nancial regulatory bodies with overlapping juris-dictions and a lack of centralized and standard-ized information.

The Mexican stock market had been reformedeven before the banking sector was privatizedand deregulated (EIU Country Profile Mexico(1994/95)). There has been the development ofnew products and the opening up of the marketto foreigners. Under new rules, which came intoforce in November 1989, foreigners are allowed

26

to purchase almost any stock through a "neu-tral" trust, although they still do not have votingrights, hi 1990, further reforms allowed foreign-ers to take a stake of up to 30 per cent in stockmarket intermediaries. It is, therefore, not sur-prising that the stock market index changed fromboom in early 1994, when capital inflows werestill positive, to bust in late 1994, when foreigninvestors withdrew their funds.

The problem is not the mere size of inflowingfunds but their source (Reisen 1995). In Asia,the equity-related share of portfolio flows ishigher than in Latin America, but it is at thesame time likely to come from more stablesources. Pensions funds and insurance compa-nies often limit their investment towards thosecountries that have been assigned investment-grade credit ratings by rating agencies such asMoody's and Standard & Poor's. Currently,only Chile and Colombia in Latin America carrythe investment grade stipulated by the portfolioallocation guidelines of pension funds, while inAsia the grade is enjoyed by China, Indonesia,Korea, Malaysia, Taiwan and Thailand. Thisexplains why by 1993 UK pension funds (forwhich such a breakdown is available) had in-vested 4.6 per cent of their assets in Asia, com-pared with only 0.6 per cent in Latin America.Although Chile and Colombia and the Asiancountries are likely to benefit from this morestable type of equity-related investment, theystill restrict short-term capital inflows. Theopening of equity portfolio investment to for-eigners in a situation where the country still hasa minor credit rating — as was the case in Mex-ico — is at least a high risk strategy.

Labour Market Policies

Labour market and wage flexibility are of cru-cial importance for the monetary and exchangerate policy to achieve the macroeconomic tar-gets. Real wage flexibility is necessary in bothfixed and flexible exchange rate regimes toachieve real exchange rate adjustment. But thepressure on nominal wage flexibility is higher ina fixed exchange rate regime, where the realexchange rate can only be adjusted via adjust-ment of nontraded goods prices, i.e., the price oflabour in the first place. The same holds for a

liberal trade regime and a liberal institutionalframework for foreign direct investment.23

While a liberal trade system helps to bring do-mestic prices down as fast as possible in order tostop the real appreciation effect of fixing theexchange rate, a liberal institutional frameworkis necessary to provide stable finance for cover-ing emerging trade deficits. Some of these issueshave already been analysed in Chapter II.Hence, the following concentrates on labour-related policies.

In Mexico, wage negotiations have been partof the macroeconomic reform programme be-cause guidelines for wage adjustment have beenincluded in the Pacto agreements. This wouldlead one to expect that wages would be adjustedconsistent with the rate of crawl of the nominalanchor, i.e., the exchange rate. If, e.g., the rateof crawl is 0.0004 pesos per day this wouldresult in an annual depreciation of 4 per cent.Given a US inflation rate of 5 per cent, thiswould result in a target for the domestic inflationrate of 9 per cent. Wage inflation could behigher to the extent

- that an additional devaluation could occurbecause the present exchange rate has someroom to move within the band,

- that inflation of nontraded goods prices ishigher than average inflation, and

- that the equilibrium real exchange rate ap-preciates.

Especially in 1990 and 1991, the realizedwage increases exceeded appropriate levels(Table 10). As a consequence, the wage spreadbetween Mexican wages and US wages in USdollar became even larger than the real exchangerate appreciation measured by purchasing powerparity. Taking 1987 as the base year, this led tothe result that at the end of 1994 the nominaldevaluation and the low inflation rate wiped outthe foregoing real appreciation completely, whileMexican wages still had increased by 39.0 percent relative to US wages.

This observation fits into the picture that —despite Mexico's comprehensive programme ofliberalization and structural reform — the la-bour market has remained relatively regulated(World Bank unpublished material). The exist-

27

ing framework of labour legislation has resultedin significant inefficiencies:

- High explicit and implicit labour costs havepresented both a barrier to the growth of for-mal sector employment, and a burden for in-ternational competitiveness. Total nonwagelabour costs would add 31 or 50 per cent ifcurrent programmes were adequately financedby contributions. The comparable costs inChile are 21 per cent and even in OECDcountries only Spain, France, and Italy areabove the 31 per cent level but not above the50 per cent level.

- Excessive restrictions against internal andexternal labour mobility have hampered pro-ductivity growth. Large mandated severancepayments have substituted for a well-designedpension system and an adequate unemploy-ment insurance. Within the OECD, onlySpain and Italy, both equipped with highlyrigid labour markets, mandate equally largeseverance payments.

The outcome of the system is not only ineffi-cient but also inequitable. It discriminates infavour of middle- and upper-middle-incomeclasses employed in the formal sector andagainst labour in informal and rural sectors, i.e.,the poorest and the worst equipped for the struc-tural changes inevitably accompanying Mexico'sfurther integration into the world market. There-fore, labour market reforms comprising lowermandatory nonwage costs and the introductionof a pension system and an unemployment insur-ance, e.g., like in Chile and Argentina, are ur-gently required to ease real integration andmacroeconomic adjustment. Additional meas-ures should comprise human capital develop-ment and the modernization of the collectivebargaining framework allowing more flexibilityat sectoral and firm levels.

Evaluation of the 1995 Reforms

The run down of foreign exchange reserves inDecember 1994 forced the Mexican authoritiesto switch to a floating exchange rate regime withlimited interventions. The macroeconomic re-forms during the first quarter of 1995 had fourbasic components:24

Restrictive fiscal policy. Budget targets havebeen modified from a balanced budget to a sur-plus of 0.5 per cent of GDP. To achieve this,fiscal policies followed the traditional lines, i.e.,expenditures were to be reduced with greaterspending cuts in investment than in current ex-penditure. The devaluation effect is expected tobe neutral with respect to revenue, since thehigher cost of external debt service will be offsetby greater revenues from petroleum sales. Thisfiscal package had to be adjusted in March byraising the VAT rate from 10 to 15 per cent,additional price increases of publicly providedgoods, and additional spending cuts.

Restrictive monetary policy. After exchangerate targeting broke down, monetary policygoals became the only nominal anchor. There-fore, the monetary programme establishes a limiton the growth of net domestic assets of newpesos 10 billion, which is equivalent to 17 percent of the monetary base at the end of 1994.

Wage restraint. Initially, the wage accordsincluded in the Pacto signed in September 1994,which targeted a total rise in wages of about 10per cent (including productivity bonus and taxcredits), were upheld. However, the modificationof the macroeconomic programme in March1995 appeared without the traditional consensusof the signatories of the Pacto and stressed theneed for an agreement on collective bargainingcontracts through free negotiation between therespective parties at the company level.

Structural measures. To complete the ad-justment, the programme also includes new pri-vatizations, a further opening of the financialsystem to foreign investment and increased de-regulation. To prevent inefficiencies of financialcontracts stemming from uncertainties about thefuture inflation rate, units of investment (uni-dades de inversi6n; UDIs) were introduced. Thisis basically an instrument to index financial in-struments because it provides a unit of accountthat is adjusted daily to the actual inflation rate.

If properly implemented, the 1995 programmecorrects much that has been criticized above. Itmaintains fiscal consolidation, while increasingthe tax burden on private consumption, it stabi-lizes money supply, while allowing a monetary

28

contraction to put a limit on price increases,it plans a significant wage restraint, whilestrengthening a trend towards further deregula-tion, liberalization and privatization. Hence,internal reform can be expected to improve theeconomic fundamentals that determine Mexico'ssolvency. At the same time, international finan-cial assistance of $51.8 billion targeted at in-creasing the maturity and the peso-denominationof public debt should be sufficient to guaranteeMexico's liquidity.

This means that economic policy has beenadjusted in a meaningful way and that the short-run economic development in Mexico now de-pends on the market reactions, i.e.:

- How long will it take to convince privateagents that the new nominal anchor will beactually sustained and will provide an effec-tive constraint for price increases?

- How long will it take for foreign investors toregain confidence in Mexico's economic pol-icy and on which level will foreign capitalflows stabilize?

The modifications not only of the reform pro-gramme but also of the economic targets thattook place in March 1995 indicate that a returnto a stable macroeconomic situation will stilltake time. The target for the current accountdeficit that could be financed was adjusted from$14 billion to $2 billion, inflation is projected toreach 42 instead of 19 per cent, the exchangerate target had to be increased from 4.5 to 6.0new pesos per dollar, and a real contraction ofGDP of 2 per cent is expected now, while only areduction in real growth to 1.5 per cent wasexpected before. While external balance is nowsecured by the floating exchange rate, which canadjust to whatever domestic inflation and exter-nal capital flows require, regaining the internalbalance seems to be at risk. An inflation ratethat is more than 100 per cent above the targetconsistent with the tight monetary policy isbound either to be reversed soon or to produceadditional real contraction and unemployment.Obviously, the market tests the credibility of thenew nominal anchor, i.e., a money supply target,which has now to be sustained to gain credibil-ity.

2. Alternative Strategies forMacroeconomic Management

Although it is to early to judge on the effective-ness of the monetary anchor, the higher thanexpected inflation rates in the first quarter of1995 support arguments that the peso/dollarexchange rate is a more adequate nominal an-chor for the Mexican economy: "Market forcesin Mexico are accustomed to using the dollar-rate as a point of reference. This attitude is verymuch based on history, where monetary stabilityhas been the exception. As such, although thefree float of the peso on the foreign-exchangemarket is an indispensable measure in the shortterm, it seems premature to implement it as apermanent policy, hi consequence, there must bea rapid return to an exchange-rate regime mostappropriate for a small country which is open totrade" (GFB Informe Econdmico (January1995)). To judge on this hypothesis it is neces-sary to know the alternatives. Hence, the follow-ing discussion will not be in theoretical termsbut will provide examples of a strictly fixedexchange rate (Argentina) and of rule-based ex-change rate management (Chile and Israel),which has been recently implemented, for thetime being, with success.

a. Implementing a Sustainable FixedExchange Rate

With the exception of a monetary union, thecurrency board is the most radical way to im-plement a fixed exchange rate system. Its basicfeature is the full coverage of the monetary baseby foreign exchange, which is guaranteed by amonetary policy that satisfies each excess sup-ply and demand for the domestic currency inexchange for an anchor currency at a given ex-change rate.25 Such a currency board — al-though in a modified version — has been at theheart of the Argentine stabilization policy sinceApril 1991, when the Convertibility Plan cameinto force (Schweickert 1994a). hi addition tothe almost complete elimination of an autono-mous monetary policy by the currency board,the Convertibility Plan has several components

29

that should speed up the convergence of Argen-tine inflation towards an industrial country level:

- The financing of fiscal deficits by the centralbank is prohibited. This is a necessary condi-tion for the implementation of the currencyboard. A radical privatization process andfiscal reforms have eliminated the fiscal defi-cits and have established the credibility of thecurrency board.

- The peso has become fully convertible andfixed to the US dollar, which could have beenused as a legal tender. This includes the use ofdollar-denominated deposits and shouldstrengthen substitution possibilities betweenthe two currencies and, hence, the credibilityof the fixed exchange rate.

- A substantial trade liberalization has beencomplemented by numerous decrees onchanging regulations to maximize competitionand the pressure on domestic inflation to con-verge.

Exchange-rate-based stabilization via theConvertibility Plan was quite successful. Start-ing with hyperinflation in 1990, annual con-sumer price inflation came down to 4 per cent atthe end of 1994, implying that the initial realappreciation to be observed in exchange-rate-based stabilization programmes had beenstopped and even reverted. This success wasachieved notwithstanding substantial expansion-ary pressures from capital inflows. Capitalflows have changed their direction, and Argen-tina has received substantial net inflows since1992. The nominal peso/dollar exchange ratehas been below the 1:1 parity since April 1991.This means that there has been an excess supplyof dollars at this parity, which has been ab-sorbed by the central bank. As implied by theconvertibility law, this has been directly trans-lated into an increase in money supply, and themonetary base more than tripled in real termsfrom 1990 to 1993. Market-driven expansion ledto real economic growth after years of stagna-tion or decline.

However, the external balance situation in1994 signalled that the expansionary first phaseof stabilization had possibly come to an end.The net inflow of foreign exchange was becom-

ing increasingly dependent on capital inflowsother than foreign direct investment because thereal appreciation steadily increased the tradedeficit. This had two consequences: the expan-sion of the foreign exchange reserves was un-likely to be sustainable, and the reserve positionwas becoming riskier. Indeed, the net reservesinflows became flat in 1994, a moderate loss offoreign exchange and, hence, a reduced mone-tary expansion had to be expected for 1995. Thespeculative wave that hit Argentina after thefailure of exchange-rate-based stabilization inMexico led to a sharp deterioration of capitalinflows and losses of foreign exchange. Becauseof this external shock, the risks of the stabiliza-tion concept materialized and the peso-denomi-nated money supply contracted sharply.

Nevertheless, Argentina sustained the fixedexchange rate. This was possible because of twosignificant differences compared with the Mexi-can implementation of exchange-rate-basedstabilization.

- The full coverage of the peso monetary baseby foreign exchange allows even for a fulldollarization at the given exchange rate. Thecentral bank voluntarily exchanges the pesoreserves of the commercial banks into foreignexchange reserves to reduce the excess de-mand for US dollars and to limit exchangerisk exposure. Additionally, the parallelmonetary system denominated in US dollarsdampens reserve losses because these aggre-gates are much more stable than the aggre-gates denominated in pesos.

- The exchange rate is fixed by law. Authoritieshave not changed the rules of the game duringsome smaller speculative attacks on the pesosince its fixing in 1991. Additionally, the reli-ance on price signals rather than negotiationsin Argentina since that time has helped privateagents to understand that there is no alterna-tive to a quick adjustment.

As a consequence,26 domestic inflation wasfurther reduced by constant consumer prices inFebruary and by a monthly deflation of 0.4 percent in March which helped the real depreciationprocess that had already begun in 1994. Bankingdeposits also stabilized in March, and the con-

30

traction of the monetary base (determined byreserve flows) was nearly stopped. It has to beacknowledged, however, that — similar toMexico — this result required additional fiscalreforms and was supported by some money fromthe IMF.

Generally, the Argentine monetary systemprovides a blueprint for a sustainable and,hence, credible fixing of the exchange rate. If thepreference for the US dollar in Mexico is strongenough to justify the use of the peso/dollar ex-change rate as a nominal anchor, a renewedfixing or quasi-fixing of the parity should beimplemented close to the Argentine blueprint.But the Argentine experience has also demon-strated the significant risks associated with theconcept even if radically implemented. Ulti-mately, the risk of speculative or at least of un-stable capital flows that translate into instabili-ties of the money supply can only be ruled out ina monetary union.27

b. Rule-Based Management of a FlexibleExchange Rate

Rule-based management constitutes a compro-mise between a currency board and a floatingexchange rate. It is characterized by the defini-tion of a central parity and the width of a bandwhich allows the nominal exchange rate to fluc-tuate around the central parity. There are twoexamples for such regimes — Israel and Chile— which may be telling for Mexico for tworeasons. First, they have been adopted followingfailed exchange-rate-based stabilization experi-ments and a subsequent period of maxi-devalua-tions. Second, for the time being they have beensuccessful.28 Inflation approached one-digitlevels while internal and external equilibriumwas maintained. During the period 1988-1993,real GDP grew by 7.2 per cent and 4.4 per centin Chile and Israel, respectively. The currentaccount deficits peaked in 1993 (Chile: 5.1 percent, Israel: 2.1 per cent) due to large capitalinflows, but generally remained significantlybelow these levels. The two countries adoptedthe following exchange rate policies (Helpman etal. 1994):

The Israeli government adopted an exchangerate band in January 1989. The band consistedof a fixed new Israeli shekel/basket central par-ity with a 3 per cent fluctuation zone around thisparity. The band's width was enlarged to 5 percent in March 1990. hi December 1991, after anupward adjustment of the central parity, theauthorities relaxed the fixity of the central parityand announced an upward crawl of the exchangerate band, hi addition, an official inflation targetwas announced for the first time. The rate ofcrawl of the central parity was set at 9 per centper year, to reflect the difference between Is-rael's inflation target and a forecast of foreigninflation for 1992. The announced rate of crawlfor the central parity was reduced to an annualrate of 8 per cent per year starting from Novem-ber 1992 and to 6 per cent per year starting fromJuly 1993, and the announced inflation targetsfor 1993 and 1994 were 10 and 8 per cent re-spectively.

The Chilean authorities adopted a policy ofdaily adjustments in the peso/dollar referenceexchange rate in 1985. At the start of eachmonth, the authorities announce the size of thedaily exchange rate adjustments for that month,based on the difference between domestic infla-tion in the previous month and a forecast offoreign inflation. The width of the band was 2per cent around the central parity in the initialphase, increased to 3 per cent in January 1988,and further widened to 5 per cent in June 1989.hi January 1992, there was a discrete revalua-tion of 5 per cent in the central parity, and theband's width was increased to 10 per centaround the reference rate. Since July 1992, theband policy has been defined in terms of abasket of foreign currencies and not in relationto the US dollar, as in the earlier periods.

Both countries — contrary to Mexico — in-creased the flexibility of their exchange rateregimes over time by moving to a passivecrawling peg as central parity and by increasingthe width of the exchange bands. This shows aclear preference for maintaining external equilib-rium. If the actual exchange rate remains at thecentral parity, this implies a constant real ex-change rate. Hence, the exchange rate system is

31

neutral with respect to the real exchange rate. Ifthe actual exchange rate moves to the upper(lower) limit, the real exchange rate depreciates(appreciates). Hence, the exchange rate systemallows real exchange rate adjustment.

While the two countries have shared commonfeatures of the exchange rate policy, the impli-cations for monetary policy are different to someextent. Since in Israel the passive crawl is ad-justed only annually and calculated on the basisof an inflation target, the autonomy of monetarypolicy is restricted to deliver this target. Like-wise, since in Chile the passive crawl is adjustedeach month and calculated on the basis of pastinflation, monetary policy has a significant dis-cretionary power. This power is furtherstrengthened by Chile's treatment of capitalflows. While long-term-oriented foreign directinvestment is encouraged by extremely liberalregulations, short-term external borrowing isdiscriminated by a 30 per cent tax on loans withmaturity of less than one year.

From the Mexican perspective it is worth tonote that a passive crawl with a band may guideexchange rate expectations but gives up the ex-change rate as a nominal anchor. The outcomefor domestic inflation depends on the monetarypolicy. The credibility of monetary policy, i.e.,of the central bank, has to be higher in the Israelicase because the inflation target has to beachieved.

The revision of the inflation target in Mexicodemonstrates that it is still a long way to go forthe Mexican central bank to establish the credi-bility of its monetary targets. Hence, using theChilean model could be characterized as being alow-risk strategy for returning to exchange ratemanagement in Mexico that gives priority to themaintenance of external equilibrium in order tostabilize trade and investment perspectives.29

But even this low-risk strategy would need tostrengthen the relation between the money sup-ply and domestic prices via further liberalizationand a strong commitment to pre-announcedmonetary targets. Establishing a nominal anchorfor the Mexican economy in this way could beused to bring inflation down gradually to the USlevel, hi a medium-term perspective, if thecredibility of monetary policy is fully estab-

lished, the exchange rate system could be modi-fied to approach the Israel model including anexplicit inflation target. Such a strategy appearsto be the most adequate one to provide the "softlanding", which is so difficult to achieve by ex-change-rate-based stabilization.

3. Policy Recommendations

The failure of exchange-rate-based stabilizationin Mexico exemplifies the systematic risks of theconcept:

- Stabilization is achieved by risking strongimpediments to exports and adjustment pres-sure to import-competing industries;

- monetary stability strongly depends to a largeextent on the stability of trade and capitalflows, i.e., on external factors that are exoge-nous for the host country;

- even if external shocks are ruled out, thesmooth functioning of an exchange rate an-chor requires a more or less perfect function-ing of market mechanisms, i.e., flexible pricesand quick supply response;

- the adequate reform effort is unknown ex anteand also difficult to manage because of a con-strained reform capacity or a reduced willing-ness to reform when capital inflows allow toexpand absorption.

Generally, capital inflows provide a breathingspace for domestic policy to be successful on thereform front. The Mexican case demonstrates,however, that even 5 years time and far-reachingreforms have been insufficient to provide a "softlanding". It seems, therefore, advisable to substi-tute the high risk by a low-risk strategy formacroeconomic management if floating ex-change rates are politically not acceptable. Rule-based exchange rate management is such a low-risk strategy. It implies

- to continue stabilizing the exchange rate via arestrictive monetary policy;

- to start limiting exchange rate flexibility witha passive crawl as central parity and widebands;

32

- to limit exchange rate flexibility further to theextent that monetary policy becomes credibleand efficient goods and factor markets are es-tablished;

- to improve these preconditions by giving fis-cal priority to taxing consumption and tospending on infrastructure and human capitaldevelopment, by strengthening the financialsystem, especially for the banking system, tomake it a sound system for collecting and ef-ficiently distributing loanable funds, bystrengthening the official labour market viareducing nonwage labour costs and impedi-ments to mobility, and by diversifying and

expanding exports as well as attracting FDI(see Section II.c).

The present involuntary floating of the pesogives monetary authorities a chance to improvepolicies in these respects without unnecessarilytying their hands with an overly restrictive ex-change rate regime, hi addition to the fact thatthere is no alternative to this policy in the shortrun, it may also provide a test whether theMexican economy actually needs a nominalanchor in the form of a fixed or quasi-fixed ex-change rate.

IV. Perspectives and Policy Recommendations

Short-run economic turbulences cannot obscurethe perception that Mexico's attractiveness as ahost for both domestic and foreign investment isvery likely to benefit from two positive devel-opments that were initiated before the crisisbroke out: First, economically, Mexico's realcapital stock has undergone substantial mod-ernization during the last few years and can beexpected to materialize in much higher produc-tivity increases than before. Second, institu-tionally, unilateral reforms of the trading regime,the implementation of NAFTA and the multilat-eral trade liberalization in the GATT/WTOframework will not only contribute to open theMexican market further, but will also increasethe degree of stability and predictability inMexican policy making. Membership in theOECD is conducive to more stability, too.

To make these developments fully effective,however, requires a number of steps to be taken.They are necessary in the sense that withoutthem the two developments — even if pursuedfurther—cannot bear fruits:

First, it is of utmost importance to restoreboth a noninflationary environment and stabilityof the real exchange rate. Bearing in mind, thatin principle, Mexico prefers exchange-rate-basedmonetary polices, the study proposes a moreflexible policy than the quasi-fixing until

December 1994 to be introduced after the transi-tory period of floating. Yet, even this moreflexible scheme requires substantial disciplineand consistency in wage policies, fiscal policiesand monetary policies. If successful, such pack-age will trigger higher domestic savings andmore efficient allocation of funds. Nevertheless,choosing a nominal external anchor through ex-change rate targeting will remain an approachthat is exposed to risks beyond the responsibilityand influence of the Mexican authorities.

Second, bottleneck factors such as in humancapital formation and infrastructure must beremoved provided that the net profitability ofrelated projects can be assessed a priori withsufficient probability.

Third, regional diversification of domesticactivities can be achieved through abandoningall measures that discriminate against the agri-cultural sector. This would not only help to meetthe crucially important targets of more equityand alleviation of poverty. It would also supportstimulating factors coming from the interna-tional arena in terms of higher world marketprices for many agricultural products after theimplementation of the Uruguay round.

Fourth, Mexico should launch initiatives tolink themselves more to non-NAFTA sourcingand export markets — in particular, to the Asianpart of APEC and to Europe, but less so to

33

Latin America, as these markets are less absorp-tive. The relatively low attractiveness of Mexicofor Japanese investors, for instance, is a disturb-ing phenomenon if it is viewed in the light of theubiquitous nature of Japanese foreign invest-ment.

hi spite of its richness in oil resources, Mex-ico is one of the few countries that can be ex-pected to overcome the Latin American syn-

drome of commodity-based development, socialsegmentation and monetary volatility. There is amiddle class strongly interested in monetarystability and economic growth and prepared tocontribute net savings to the financial sector.Finally, it is increasingly understood in Mexicothat abundance in fossil energy has more oftenbeen a source of temporary windfalls than thebase for a sustainable catching-up process.

Appendix: Stylized Facts about Exchange-Rate-Based Stabilization

To see how a fixed exchange rate can stabilizean economy,30 we assume that the economy is inmacroeconomic equilibrium and net capitalflows are zero. The difference between domesticand foreign inflation is compensated for bynominal devaluation, so that the real exchangerate is constant, i.e., the real exchange rate is inequilibrium but inflation is significantly higherthan abroad. If the exchange rate is fixed in sucha situation, inflation decreases immediately be-cause the price increases for traded goods arecurbed by world market conditions. But ongoinginflation for nontraded goods will lead to animmediate real appreciation.

Real appreciation creates an excess demandfor traded goods and an excess supply of non-traded goods. This is because traded goods be-come relatively cheaper and demand shifts fromnontraded to traded goods. Excess demand fortraded goods implies a trade deficit, an outflowof foreign reserves, and — with a passive mone-tary policy — a monetary contraction.31 As aconsequence, absorption decreases, the demandfor traded goods declines and the trade imbal-ance is reduced. But the decrease in absorptionfurther increases the excess supply of nontradedgoods. This exerts a pressure to reduce theprices of nontraded goods. Domestic inflationmust be even lower than abroad in order to re-move the real overvaluation and the excess sup-ply of nontraded goods caused by the initial realappreciation.32

A necessary precondition for private agents toadjust prices is that they expect the monetary

contraction to occur. If this is not the case,ongoing inflation, growing real overvaluation,and increasing internal and external imbalanceswill end the stabilization programme soon.Therefore, the credibility of the monetary con-traction becomes a basic precondition for theflexibility of prices and for the success of theexchange-rate-based stabilization.33 Problemswith its credibility result from three macro-economic constraints: the government budget,the foreign exchange reserves and the unem-ployment.

The need to finance the government budgetmay constrain the possibility of a monetary con-traction in low-income countries because collect-ing the inflation tax and borrowing on narrowdomestic capital markets play a significant rolein financing government expenditure. Therefore,an exchange-rate-based stabilization needs fiscaldiscipline, i.e., expenditure has to be reducedand/or alternative taxes have to be raised. Oth-erwise growing pressure on the central bank toincrease the money supply would be expected byrational private agents. Hence, prices would notbe adjusted.

The outflow of foreign exchange reservescould run down the stock of reserves beforetrade is balanced, hi this case, a nominal de-valuation will be expected, and this expectationwill lead to a devaluation even before the re-serves are actually depleted.34 Such a devalua-tion is typically avoided in the short run by in-creasing protectionism to stop reserve losses

34

(Williamson 1987). Both reactions diminish thepressure on private agents to adjust prices.

If the monetary contraction is possible, thequestion arises, if it actually occurs. The tempo-rary fall in demand provides strong incentivesfor the authorities to change the programme andto avoid temporary unemployment via a mone-tary expansion. This means that the announce-ment of a fixed exchange rate is time-inconsis-tent and private agents have an incentive not toadjust prices but to wait for the policy switch.

hi the case that private agents judge macro-economic constraints not to be relevant, mone-tary contraction is credible and guarantees apressure to reduce the prices of nontraded goods.Whether these prices are actually adjusted de-pends on the price setting behaviour in the realsphere of the economy. The fall of nontradedgoods prices will not occur in the presence ofindexation and inflationary inertia (Edwards1993: 5-10) and a low level of competition, hithis case, the monetary contraction will lead tohigher unemployment rather than to a real ex-change rate adjustment

The adjustment towards a new equilibriumbecomes easier if the country is able to attractcapital inflows. There are basically three reasonsfor an increase in capital inflows:

(1) Commercial banks and official lendershonouring the macroeconomic reform effortsmay grant access to new credit lines and in-crease foreign direct investment. Such capitalinflows are of a permanent nature as long as thereform is sustained.

(2) Private agents shift their portfolio towardsdomestic assets if they expect an undistortedmacroeconomic environment and a higher prof-itability of investment in the country undergoinga stabilization programme. This capital inflowcontains not only permanent but also temporarycomponents such as repatriated capital flight.

(3) Private agents shift their portfolio furthertowards domestic assets because speculativewindfall gains can be earned in the short run dueto high nominal interest rates and a guaranteedexchange rate. This type of capital inflow is oftemporary nature.

Large capital inflows finance emerging tradedeficits and increase foreign exchange reserves.Hence, the money supply grows and the pricesfor nontraded goods do not have to be adjusteddownwards, i.e., domestic inflation has not to belower than inflation in the anchor currency.However, such an equilibrium may not be sus-tainable. First, capital inflows may decreasebecause they are of a temporary nature at leastto some extent. Second, the country may experi-ence a negative terms-of-trade shock. Third, ifthe exchange rate is fixed against a single cur-rency, e.g., the US dollar, an appreciation of theUS dollar against other relevant currenciesimplies decreasing world market prices.

All these shocks have qualitatively the sameimplication for the economy. The real exchangerate becomes overvalued, the trade deficit has tobe financed by an outflow of foreign exchangereserves, and the demand for nontraded goodsfalls short of supply. This means that all theproblems described above for the case of stabili-zation without capital inflows emerge. More-over, the problems are even more pronouncedbecause of the initial expansion. This is why thereversal of capital flows typically marks the endof fixed exchange rate regimes. Monetary con-traction is not sustained and a devaluation crisisemerges: the "stabilization blues" (Guidotti andVe"gh 1992).

35

Endnotes

1 A comparison of Mexican and US trade figures suggests that exports from maquiladora industries account for 60-70per cent of US imports from Mexico, and, hence, up to 50 per cent of Mexico's merchandise exports to all destinations(GATT 1993: 3).

L See Section II. 1 .c in which the effects of agricultural liberalization are discussed for Mexico.3 A second-best approach: not to impose antidumping margins but to accept price undertakings as the EU does against

the CEECs.4 Assumptions on the change in oil prices are essential for Mexico's income position. In the model, oil prices are linked

to the price of OECD manufacturing exports. It is assumed that OPEC countries aim at maintaining a stable relation-ship between the price of their manufactured imports from the OECD area and the price of their oil exports. Hence, afall in the price of OECD manufactured exports due to liberalization and increased competition induces a fall in oilprices.

3 According to regular surveys of the International Finance Corporation (Pfeffermann and Madarassy 1991; Glen andSumlinski 1995) Malaysia had an investment ratio of 27 per cent, Thailand 24 per cent and Indonesia 22 per cent.

6 IMF International Financial Statistics (March 1995).

' Early enough, fears were nourished by empirical estimates supporting the view that in fact external factors, in particu-lar in the United States, played an important role in encouraging short-term capital to leave the United States and toenter Mexico. Among such factors, the decline in US interest rates, continuing recession and capital account develop-ments in the United States figured prominently (Calvo et al. 1992).

8 IMF International Financial Statistics (March 1995).

These three countries are the leading investors in Mexico together with the United Kingdom. FDI statistics for theUnited Kingdom are not available after 1991. In this year, Mexico held a share in UK total FDI (at book value) of only0.3 per cent in all industries and 0.4 per cent in manufacturing. These shares were the same as in 1987 (UK, CSO1993).

*" A breakdown of Japanese investment by industries is only available for host countries with a relatively large amount ofJapanese FDI. Mexico does not belong to this group.

Bundesbank data on the stock of foreign investment in Germany in 1992, for instance, record an amount of only DM 8million of investment from Mexico, compared with DM 310 million from Argentina and DM 125 million from Brazil.

1 2 Helpman et al. (1994), EIU Country Profile Mexico (various issues).1 3 On 1 January 1993, the peso was trimmed by three zeros, one peso being worth 1,000 of the old pesos.1 Israel's and Chile's exchange rate policies are discussed in Section III.2.b as possible blueprints for the future Mexican

exchange rate regime.

^ These arguments between the government, employees and trade unions include targets for prices and wages. For anoverview, see, e.g., Dornbusch and Werner (1994). For the comprehensiveness of reforms in Mexico, see Aspe (1993)and Cline (1991).

1° See Appendix for the theoretical concept.1 On the Mexican "tradition" to produce periods of real appreciation followed by devaluations of the currency, see

Furstenberg and Teolis (1993b).

* Whether it was overvalued even before foreign exchange reserves started to decline, as argued by Dombusch andWerner (1994) and Fischer and Schnatz (1995), is as difficult to answer as to determine the equilibrium real exchangerate.

1" It could, of course, be argued that sterilizing capital inflows would have increased the size of inflows further makingsterilization noneffective (Brand and Rohm 1995). However, such a policy would have improved the coverage of themonetary base by foreign exchange.

It has, of course, to be acknowledged that there has been a lot of improvement in this area since the 1980s. For anoverview, see, e.g., EIU Country Profile Mexico (1994/95).

2 1 For an overview over reform measures, see G.O. Martinez (1994), Aspe (1994), and Welch (1993). The new regula-tory framework for the central bank is discussed in F.B. Martinez (1995).

2 2 World Bank (unpublished material), EIU Country Report Mexico (various issues), OECD (1992).2 3 While these measures tended to increase external competition (Ize 1990), domestic competition was increased by a

general deregulation of the economy. For an overview, see Martinez and Farber (1994).

24 Gpg Informe Econdmico (various issues), IMF IMF Survey (6 February 1995).2^ On currency boards and the different forms of implementation, see Hanke and Schuler (1993,1994).2 6 Recent information is derived from FM (1995) and IMF IMF Survey (17 April 1995).

36

2 ' For the benefits of such a North American Monetary Union (NAMU) from the Mexican perspective, see Fiirstenbergand Teolis (1993a). For a discussion of monetary unification from the perspective of low income countries in theEuropean case, see Schweickert (1995b).

2** For the data, see EIU (1995a, 1995b) and IMF International Financial Statistics (various issues).2 " For a more theoretical discussion of the passive crawling-peg as an exchange rate strategy for developing countries, see

Schweickert (1993: Chapter D).3 " For a more detailed discussion of the theoretical implications including a graphical presentation, see Schweickert

(1993: Chapter C; 1994b).3 1 In the following, monetary contraction means a decreasing real money supply. Correspondingly, decreasing domestic

prices mean a lower difference between inflation at home and abroad.3 2 In the absence of real shocks, the equilibrium of the real exchange rate remains constant and the actual real exchange

rate has to return to its initial level.

Contrary to a stabilization programme with flexible exchange rates, the extent of the monetary contraction is unknownat the beginning of the programme. This makes the credibility of the monetary contraction a challenging preconditionin a fixed exchange rate regime. On the advantages of stabilization with flexible exchange rates, see Schweickert(1993).

•** See the literature on balance-of-payments crises summarized by Aghevli and Montiel (1991).

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