Financial Liberalisation in Semi-Industrialised Economies
The Mexican Case
Optimistic expectations about capital account liberalisation have not been borne out in reality in Mexico. There have been negative outcomes in a number of areas – overvaluation of the currency, worsening of the current account, decline in
domestic savings and many others.
JULIO LÓPEZ, GUADALUPE MÁNTEY
I
did not contribute to an acceleration of income growth and stabilisation of the balance of payments, but hindered economic expansion. It ignored two important features of developing countries, which are their dependence on foreign technology and the weakness of their national currencies.
We organise the paper in six sections. The first describes capital account rules before the 1982 debt crisis, and the breakdown of the institutional setting because of negotiations for debt-restructure under the Brady Plan. In sections II and III, we show the disruptive effects the country’s opening to unmanageable international capital flows had on the real and financial domestic markets, which eventually steered the economy to the twin crises of 1994. In sections IV and V, we consider the role of growing foreign control of domestic firms in disintegration of domestic production, worsening of the current account, and increasing external financial dependence, after the crisis. We also call attention to the implications of the country’s dependence on foreign technology and the weakness of its currency. In section VI, we summarise our conclusions.
I Financial Liberalisation under Washington Consensus
Mexico’s economic policies were earlier based in the so-called import substitution strategy and came in unison with strong state intervention. Thus, they were similar to the policies adopted in the other large Latin American countries, except for the following. From the time when Mexico replaced its metallic currency by a public fiduciary currency, in the 1930s, free convertibility has been a main objective of economic policy. A lengthy border (more than 3,000 km) with the United States, and the US monetary authorities support for stabilisation of the peso-dollar exchange rate have since then dissuaded Mexican governments from instituting exchange rate controls1 [Cardero 1984].
Therefore, controls on the capital account of the balance of payments were always mild. Their aim was to foster economic development, by protecting domestic producers from foreign competitors and preventing speculation on domestic assets. Stabilising the exchange rate was not their main purpose.
The 1982 currency crisis, and the debt negotiations under the Brady Plan that followed came with the arrival of a new generation of politicians and public servants. Though they belonged to the political party which had traditionally ruled the country,2 they were much more attuned to neoliberal ideas. In this new context, the government decided to remove prevailing restrictions on foreign investment, and to carry out other liberalising reforms under the Washington Consensus guidelines.
The proponents of this development strategy relied on the efficient market hypothesis. They claimed that trade liberalisation, financial market deregulation
Economic and Political Weekly May 13, 2006
and free international capital mobility Graph 1: Foreign Investment Flow and Currency Appreciation
(Four Quarter Moving Average)
would bring about many kinds of benefits 38to indebted developing countries. First, they would pull fresh foreign resources 36
into these economies, which would con
34
tribute to modernising their productive
32
-40 -20 0 200 400 600 800 (US Dollars)(Real Exchange Rate)
structure. Second, they would enable
domestic producers to compete more
favourably in the most dynamic segments
of international markets. Producers would
be able to import the high technology
inputs not yet produced domestically, and
30
28
26
24
reduce costs by importing cheaper inputs 22
from abroad. Third, they would benefit consumers and stimulate a more efficient use of productive resources by exposing domestic producers to foreign competi
2004:12003:12002:12001:12000:11999:11998:11997:11996:11995:11994:11993:11992:11991:11990:11989:1
—— Foreign investment Real exchange rate
tion. Fourth, they would increase domestic Note: Y Axis is of relevant quarter in each year. savings and improve the quality of invest-
Graph 2: Current Account Deficit, International Reserves and Commercial Banks’
ment, by removing interest rate ceilings
Exposure in Foreign Currency
and abolishing bank credit rules. Finally,
40000
these reforms would compel governments
35000
to set up good policies and improve their
30000
performance, to avoid free markets impos
25000
1980:11981:21982:31983:41985:11986:21987:31988:41990:11991:21992:31993:41995:11996:21997:31998:4 —•— Commercial banks’ exposure in foreign currency International reserves minus gold —— Current account balance ing their discipline [Eatwell and Taylor
2000; Cardero 2000].
From 1983 to 1987, the authorities hastily
opened the domestic market to foreign
(US Dollars)
20000
15000
10000 5000
0
trade. They reduced import and tariffs
dramatically, and they removed non-tariff
-5000
10000
restrictions. At the same time, they pro
15000
moted bonded export manufacturing companies.3 In this period, capital account liberalisation began, and the government approved up to 100 per cent of foreign ownership in firms in non-oil export industries. Non-oil exports grew at an average annual rate of 18 per cent in that period, stimulated by currency undervaluation and depressed wage rates. Also, the share of firms with majority foreign capital ownership in export sales rose from 22 per cent in 1983 to 53 per cent in 1987. In the commercial banking sector,4 direct credit controls and interest rate regulation were also abolished. By the end of the 1980s, once the financial institutions had become solvent again the government began their denationalisation. By 1990, the denationalisation process was complete.
In 1989, when negotiations for restructuring the external debt ended, the government began to speed up capital account liberalisation. It reduced limits to corporate foreign ownership in activities that accounted for nearly 75 per cent of GDP. It also allowed foreign investors to buy domestic securities and public enterprises put on sale, and to carry out swap operations with domestic indebted firms, as proposed in the Brady Plan.
Note: Y Axis as in Graph 1.
Besides, the authorities allowed domestic financial institutions to operate in international financial markets; with some minor limits they let banks borrow abroad. They also allowed non-financial firms to place securities in foreign stock markets. Finally, the government gained cooperation agreements with foreign monetary authorities, stock exchanges and multilateral organisations, with the aim of helping to open the capital market [Cardero 2000; Guillén 2000].
In 1993, foreign financial institutions got permission to operate and place foreign securities in the domestic stock market. Shortly thereafter, the Mexican government subscribed to the North America Free Trade Agreement (NAFTA). NAFTA called for investors from other member countries to have the freedom to repatriate dividends and interest, enjoying equal treatment with national investors. At the same time it protected every foreign investment from adverse policy measures that member country governments could impose in the future.
In 1995 Mexico joined the OECD, and though the Multilateral Investment Agreement was not negotiated, a few years later the country signed a bilateral free trade agreement with the European Community, which included the core clauses of the MIA proposal as well as the provisions already incorporated in NAFTA on foreign investment, international payments and intellectual property. That agreement came into force in 2000.
II Short-Term Capital Inflow,Stock Market Inflation and the Private Credit Boom
Capital market opening pulled to the country huge international financial resources. From 1989 to 1994, Mexico received $101,935 million, because of three particular circumstances abroad. First, the US had an economic recession in the early 1990s. Second, the regulations of the US Securities Exchange Commission were
Economic and Political Weekly May 13, 2006
Graph 3: Foreign Investment and Stock Market Inflation economy was growing at the moderate rate
(Four Quarter Moving Average)
1980:41982:21983:41985:21986:41988:21989:41991:21992:41994:21995:41997:21998:42000:22001:42003:22004:4
9000000
Foreign direct investment had negligible effects on income growth in the first half
7000000
20 of the 1990s, because most of it involved
Foreign investment —— Stock market price index in dollar terms
takeovers of existing firms [Guillén 2000]. Stock market inflation too did not have a
(Stock Price Index)
5000000
significant influence on the rate of capital
(US Dollars)
15
accumulation, since net investment was
3000000
10
mostly financed out of retained earnings.
III
1000000
Reversal of Portfolio Foreign5 Investments and the 1994-95
-1000000
Twin Crises
Despite the steady growth of the current
-3000000
0
account deficit, multilateral financial in-
Note: Y Axis as in Graph 1.
changed.5 Third, international interest rates started to fall [Ros and Lustig 1999].6
The huge inflow of foreign capital had four destabilising effects in the economy. First, it appreciated the exchange rate, and it widened the current account deficit (Graphs 1 and 2). Second, it encouraged commercial bank lending to the private sector, even as their share of lending to the government declined. Third, it induced banks to increase their exposure in foreign currency, given that domestic lending rates were nearly five times higher than interbank lending rates in Eurodollar markets. Finally, it inflated the domestic stock market,7 which was too thin and shallow to absorb the enlarged demand for securities from foreign institutional investors at stable prices (Graph 3).
Despite the growing trade imbalance, the country piled up foreign reserves at a rapid pace (Graph 2). The government could therefore maintain the exchange rate peg.8 As inflation fell, international reserves increased, and the government showed concern for maintaining a stable nominal exchange rate, mainly through high domestic interest rates. Foreign investors’ confidence too increased; and because of the short-term capital gains that foreign investors could fetch thanks to rising stock prices, capital inflows were further stimulated.
Financial market deregulation, and commercial bank denationalisation, hindered central bank efforts to sterilise such sizeable capital inflows. Open market operations were of little help in regulating domestic liquidity, because interest rate differentials were too large; and as they raised interest rates, they had the perverse effect of further increasing capital inflows.
From 1989 to 1994, domestic banking credit climbed from 27 to 52 per cent of GDP; and credit to the private sector rose from 14 to 38 per cent of GDP in the same period. During the process, the rate of domestic private savings fell from 17 to 11 per cent of GDP between 1988 and 1994. Since the government budget was roughly in balance, some authors assign a key role for that fall to the rise in consumer credit (see for example Ros and Lustig 1999). We do not share this outlook and we propose that the fall in the domestic saving rate was the result of financial liberalisation. We can argue our point with aid of the macroeconomic accounting equation for saving in an open economy:
Sp +Sg ≡ SH =Ip – Sf where Sp is private savings, Sg is government savings, SH is domestic savings, Ip is private investment, and Sf is foreign savings (equal to, under simplification, to the current account deficit).
We have already mentioned that in Mexico’s experience, financial liberalisation contributed to appreciation of the domestic currency. This, coupled with trade liberalisation, brought about a huge rise in the trade and current account deficits. As a result, the relative share of domestic savings in the GDP markedly fell, even as the relative share of investment in GDP rose; and in fact rose at a faster rate than private consumption. Specifically, from 1992 to 1994, the trade deficit averaged 4 per cent of GDP, and it reached almost 7 per cent of GDP in 1994, even as the stitutions, Mexican policy-makers, and many economic analysts in the private sector kept on praising Mexico’s liberalising strategy. They based their optimism on achievements such as the following. First, a falling rate of inflation (from 30 per cent in 1990 to 7 per cent in 1994). Second, the success achieved in fiscal consolidation (with nearly three years of government surpluses). Third, the boost in manufactured exports, which had been expanding at a phenomenal annual average rate. However, they overlooked other disturbing indicators. One was the strong growth of imports (at an annual average rate of growth of 20 per cent from 1989 to 1994). Another was the currency mismatch in banks’ assets and liabilities. Last but not the least, they did not consider the growing share of bad loans in bank’s portfolios.
We may illustrate the state of confusion about the Mexican economy’s prospects with the following statement made by the governor of Mexico’s central bank, just two weeks before the exchange rate crisis of December 1994 broke out: “The size of the current account deficit is, in a way, a measure of the country’s success, not of its failure... The greater the success of Mexico as an attractive country for investment, the bigger the current account deficit will be”.9
The change in US monetary policy beginning in 1994, which launched an upward trend in international interest rates, brought about a sudden decline in the flow of foreign capital to Mexico and other developing economies. First, domestic banks faced difficulties in sustaining their credit lines in foreign banks. Second, nonfinancial enterprises were unable to roll over their foreign loans. Finally, the
Economic and Political Weekly May 13, 2006
government was compelled to exchange dollar denominated securities for the peso denominated bonds which until then were held by foreign institutional investors and to shorten the terms to maturity.
Some of the country’s main economic indicators remained stable. However, a speculative attack against the currency developed. The latter took place owing to political events,10 and because of the suspicion that under prevailing conditions in international financial markets, domestic economic agents would be unable to discharge their external obligations. Over 1994, the country’s foreign reserves declined from $24 billion to $6 billion. In December 1994, given the high degree of financial fragility, the self-fulfilling prophecies of domestic and foreign investors plunged the country into an exchange rate crisis. This straightaway led to a financial crisis, because of the high level of domestic banks’ exposition in foreign currency.
The central bank imposed a tight monetary policy on the economy in order to reduce the inflationary effects of currency devaluation and to put a brake on the substitution of foreign currency denominated assets for domestic financial assets. But naturally the credit crunch made matters worse.
High interest rates and stiff credit conditions, as well as a reduced import capacity pushed the economy into a deep recession, which led to a fall in GDP by about 6 per cent in 1995. The fall in income and profits, jointly with the rise in interest rates, rapidly eroded the quality of banks’ credit assets and the guarantees given as collateral. As the share of bad performing loans in banks portfolio rose, a credit crunch developed.
Under such conditions, which are characteristic of countries with a weak currency that liberalise the capital account of the balance of payments, the central bank was unable to fulfil its function of a lender of last resort. Since the economic authorities were unwilling to introduce controls which were needed to cope with an external financial crisis, foreign capital appeared as the only possible source of liquidity. In the first stage, this relief came from an emergency financial package negotiated with multilateral financial institutions and the US government, under severe conditionality. To gain international official assistance, the government compromised and agreed to carry out policies friendly to foreign investment. Also, the collapse in domestic firms’ market values, jointly with the exchange rate depreciation, made possible the return of foreign private capital flows to the country. But now foreign investors had more favourable conditions.
In the succeeding years, the country has gradually recovered from the 1994 crisis. However, the distortion caused by the growing participation of foreign capital in strategic sectors of the economy has dramatically changed its structure and institutions. In a certain sense these changes overhauled the economic (as well as political) fundamentals of Mexico’s economy and society.
IV Resurgence of FDI andWorsening of Current Account
The 1994 financial crisis hastened opening of financial services to foreign direct investment. In NAFTA negotiations, domestic firms in these activities had received favourable treatment, since the treaty protected them from foreign competition for six years. During this period foreign intermediaries could only have 15 per cent of the domestic market. One policy objective had been to strengthen domestic industrial and financial conglomerates, to develop scale and scope economies that would enable them to compete more advantageously in international markets.
The exchange rate crisis killed these ambitions. The 1994-95 crisis forced the government to bail out the banking sector. Three years later, as a means to recapitalise those institutions, the government resigned from the NAFTA safeguard. It passed a law that enabled foreign investors to hold up to 100 per cent of domestic banks equity, without limiting their share in the local market. The market share of foreign capital controlled banks increased from 1 per cent in 1994, to 40 per cent in 1999, 53 per cent in 2000, and 90 per cent in 2004 [Macedo 2000; Correa and Maya 2002; Berumen 2004]. That share is the highest among OECD countries.
Without the support of their banks and under the pressure of foreign competition, the larger conglomerates developed new strategies for survival, which entailed investments abroad and associations with foreign producers. For smaller firms, the joint effect of the domestic credit crunch and imports competition was devastating.
By contrast, trade liberalisation and opening of the capital account pulled towards the country foreign direct investors. The latter took advantage of lower labour and transport costs, and relocalised some production processes to compete more favourably in the US market [Moreno Brid et al 2005]. The in-bond industries also flourished.
As the economy became more exportoriented, it also showed decreasing domestic integration. The income elasticity of imports, which hovered between 0.6 and 1.8 before trade liberalisation, jumped to 3 in the period 1983-2003 (Moreno-Brid 1999). Now, the exporting firms are also the largest importers (for example imports by in-bond industries account for 80 per cent of their output value).
The Mexican experience confirms that trade liberalisation with an open capital account, in countries dependent on foreign technology, brings about a widening current account deficit, which makes the country increasingly dependent on foreign capital inflows.
Foreign direct investment, which is usually considered superior to external debt, has negatively affected the economy because of several reasons. The most important reason is that a large part of foreign direct investment involved takeover of existing local firms, and another large share was deployed in exporting industries with high import requirements. Formally, these are manufacturing firms turning out sophisticated goods. But they are little more than assembly plants of mutinationals. Besides, owing to the lack of an industrial strategy, investment (domestic or foreign) was not encouraged in the input industries, and the elasticity of imports rose exponentially. Therefore, a large part of the demand induced by exports leaked abroad, the foreign trade barrier to growth [Thirlwall 1979] was not lifted, and the growth rate of output remained modest. Thus, while Mexico’s share in world manufacturing exports rose about 2.2 percentage points between 1980 and 1997, its share in world manufacturing value added declined about 0.7 percentage points.11
Another reason foreign direct investment has failed to bring about the expected results is because of the high market power of foreign firms. Since these firms tend to be large and powerful, the degree of competition in the branches of activity in which they engage has declined. In addition, foreign investment also has promoted foreign indebtedness, because takeovers are usually leveraged and foreign firms
Economic and Political Weekly May 13, 2006 also rely on finance provided by their main companies. Finally, the assumed benefit of a fixed investment vis-à-vis more volatile short-term flows, such as loans or portfolio investments, becomes much undermined when shares of foreign firms are traded in the local stock exchange and changes in ownership can rapidly occur [Vidal 2001].
All in all, trade liberalisation with opening of the capital account, in a semiindustrialised economy dependent on foreign technology, holds back domestic industrial integration and produces a more binding balance of payments constraint to growth. This pattern of development has posed a dilemma to Mexican policymakers. As the current account worsens and larger capital inflows are required, they are compelled to preserve nominal exchange rate stability. Now though this policy, successfully lowers inflation, it also brings about a further worsening of the trade account.
V Financial Intermediation byForeign Banks and ChangingOwnership Structure
Local firms’ direct investments abroad, much like foreign direct investment inflows, are always leveraged operations, and they entail issuing liabilities denominated in foreign currency. In 2002, Mexican investments abroad amounted to $ 65 billion, from which $ 45 billion was deposits and credits. In the same year, foreign investment in Mexico exceeded 50 per cent of GDP; direct investments accounted for 20 per cent of GDP, and portfolio investments plus credit loans represented 30 per cent [Garrido 2005].
We note an increasing share of foreign financing from 1995 onwards in the largest domestic firms. These liabilities show longer terms to maturity compared with local currency loans, but they entail interest and currency risks, which endanger capital control by Mexican stockholders in the future. This is so, because in global competition, multinational enterprises are backed by their banks that provide them with credit in hard currency, and thus have both technological and financial superiority [Garrido 2005; Vidal 2000]. These conditions expose even the largest domestic firms to hostile takeovers by foreign financial groups [Singh and Weisse 1998].
Domestic banks under foreign control have gradually reduced credit to domestic production units. Instead, they have increasingly engaged in government securities trading as well as in more sophisticated operations with financial derivatives; and they direct the lower credit flows mostly to consumer loans and mortgages.
In the future, however, things may change. By law, banks are in charge of private pension funds administration and new rules enable them to invest up to 20 per cent of workers’ savings in foreign securities. Therefore, it is likely that they will provide support to foreign firms as a substitute for domestic producers. This provision will, in all likelihood, strengthen the financial superiority of foreign firms vis-à-vis their domestic competitors.
VI Closing Remarks
Our analysis shows that the optimistic expectations about the effects of capital account liberalisation have not taken place in the Mexican economy. In opposition, reforms liberalising foreign investment have exposed the economy to the instability of international financial markets, and have produced at least the following negative outcomes: (i) Currency overvaluation and current account worsening. (ii) Enlarged capital market price volatility and financial speculation. (iii) A decline in private domestic savings. (iv) Financial fragility in the banking sector, and eventually the need to sell the banks to foreign institutions. (v) A rapid increase in foreign ownership of exporting firms, disintegration of the domestic industrial structure, bankruptcy of thousands of small size firms, and the rise in income elasticity of imports.
(vi) A growing share of external finance in leading domestic firms, and the associated risk of future increases in foreign ownership. (vii) A decline in the rate of income growth, as the more severe balance of payments constraint sets a lower limit on domestic market expansion.
rnrEmail: gallardo@servidor.unam.mx
Notes
1 Only when the country’s reserve of foreign
currency was nearly exhausted, in the middle
of the 1982 external debt crisis, did the gov
ernment set up exchange rate controls which
lasted for three months.
2 The Institutional Revolutionary Party (PRI).
3 “Bonded export” manufacturing firms are called
“Maquila” in Mexico. The bonded-export
industries programme started in Mexico in
1965 to set up assembly operations for exports in the border zone, and it liberalised both trade and capital flows. These firms could be 100 per cent foreign owned at a time when foreign firms were otherwise restricted to less than 50 per cent foreign ownership. They could also import inputs duty-free and did not face nontariff barriers, on condition that their output was entirely exported. Maquila firms importing inputs fro the US and re-exporting to the US could also benefit from Tariff Item 807.00, which permits imports of goods assembled in foreign countries which use components manufactured in the US. The Maquila firms’ exponential growth really started in the mid-eighties.
4 The banking sector was nationalised at the outburst of the 1982 crisis.
5 These changes enabled US investment funds to hold foreign securities in their portfolios, and recognised Mexico’s stock market as an offshore designated securities market.
6 This large inflow reflected the boom of private capital flows to Asian and Latin American emerging markets from 1990 to 1994, which amounted to $6,70,000 million, and represented five times the inflow received by these countries during the previous five years [Calvo, Leiderman and Reinhart 1996].
7 What Toporowski (1999) has called “Capital Market Inflation”.
8 The peg had been an effective policy tool for lowering the rate of growth of domestic prices since the end of the 1980s.
9 Interview given to the weekly Tendencias Económicas y Financieras, 12-12-1994.
10 The Zapatista uprising took place in January of 1994; later came the assassination of the presidential candidate of the ruling party first, and of the secretary general of that same party later.
11 We may contrast this with China’s and India’s experiences during the same period, where the share in world manufacturing exports rose about
2.2 and about 0.5 percentage points respectively, and their share in world manufacturing value added rose about 2.5 and 0.6 percentage points respectively [UNCTAD 2002]
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