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This is an author version of the contribution published on:
Comparative Economic Studies,
2010, 52 (4), pp. 589-609. doi: 10.1057/ces.2010.18
The definitive version is available at:
http://www.palgrave-journals.com/ces/journal/v52/n4/full/ces201018a.html
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Mexico and the IMF in the 1990s
Old and New Issues on Capital Account Liberalization and Emerging Market Countries
Manuela Moschella
Abstract:
The 2007-08 financial crisis has once again prompted a lively debate on the benefits and risks
of capital account liberalization in emerging market countries. This paper contributes to this
debate by looking back at the 1990s through the lenses of the IMF. Based on archival
research, the paper argues that the IMF looked at Mexico as evidence of the benefits of global
financial integration both before and after the crisis, focusing on macroeconomic conditions
and underestimating the soundness of the domestic financial sector. In the conclusions, the
paper links the findings with the debate that followed the subprime crisis.
Keywords: Mexico; IMF; capital account liberalization; crisis
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The financial crisis that started in the summer 2007 in the small segment of the U.S. subprime
market has rekindled the debate about the benefits and risks associated with the integration of
world’s capital markets. This is all the most so for emerging market countries. Indeed, one of
the most evident signs of the spread of the crisis from advanced economies to emerging
markets was the slowdown in private capital flows. Specifically, foreign investors withdrew
from emerging economies equity and debt funds while foreign banks cut lending as part of
the process of global deleveraging. The sudden stop of capital inflows put severe downward
pressure on the exchange rates and harmed the real economy, pushing most emerging
economies into recession. The large reversal of capital flows to most emerging markets in the
final quarters of 2009, as a consequence of the ease in global monetary condition, has then
raised new problems for the recipient countries that face the challenge of stemming
inflationary pressures and asset bubbles. Against this backdrop, several national authorities
have
1
introduced
or
considered
the
use
of
capital
controls
and the intellectual approach to financial liberalization is once again under serious
consideration in economic and political circles alike (Subramanian and Williamson, 2009,
The Economist, 2009). This paper contributes to the current debate by looking back to the
1990s by analyzing the economic trajectory of a country – i.e. Mexico – that, as most
emerging market economies today, experienced the volatility of capital flows and the policy
management problems associated with large capital inflows. Specifically, the paper
investigates the role that international financial integration played in the process of economic
transformation that took place in Mexico since the late 1980s and in the financial crisis that
hit the country in 1994-95. In order to carry out the research, the paper takes an outside-in
perspective by analyzing the Mexican case through the lenses of the International Monetary
3
Fund (IMF) and its policy advice on capital account liberalization and its domestic prerequisites.
Why is it relevant to analyse Mexico’s economic performance through the eyes of the
Fund? The IMF provides a privileged observation point for the purposes of this study in
several respects. Firstly, the Fund, created in 1944 to coordinate member states’
macroeconomic policies, is an intergovernmental organization, with a quasi-universal
membership. Looking at Mexico from the Fund’s perspective can thereby provide an insight
into the thinking on capital issues that came to dominate within the international community
or, at least, by the most industrialized economies (Pauly, 1997; Williamson, 1990; 2004).
Secondly, the fact that the IMF staff is primarily recruited from PhD economists also makes
the IMF an interesting laboratory to gauge the prevalent thinking among academic
economists on the policies deemed necessary to foster economic growth. In other words, the
analysis of the IMF’s assessment on Mexico’s economic performance allows us get some
insights into the then-dominant intellectual approach on capital liberalization and to
appreciate the changes occurred in that approach over time. Finally, in the aftermath of the
subprime crisis, the Fund has taken on a central role not only in providing financial assistance
to countries in need, especially those countries in Central and Eastern Europe that suffered
the most from a sharp reversal of capital flows. The IMF has also been deeply involved in the
analytical work that aims at understanding the causes of the crisis and at elaborating
appropriate policy responses. The conclusions reached by the IMF in the conduct of its
analytical work can thereby be compared to those reached by the IMF in the 1990s.
In looking at the Mexican economy from the outside-in, the paper argues that the IMF
looked at Mexico as a prime example of the benefits of global financial integration. In other
words, the cross-time comparison of the IMF’s analysis of the Mexican case before and after
the crisis shows that the Fund interpreted Mexican economic performance in a way that
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supported the view according to which the liberalization of the capital account is a crucial
policy to promote domestic economic growth. Interestingly, then, the IMF’s interpretation
went unchallenged even on the heels of the 1994 financial crisis when Mexico suffered from
a severe capital flight. Rather than marking the reversal of the international consensus on the
merits of financial liberalization (Krugman, 1995), the Mexican crisis reinforced that
consensus as the empirical analysis is going to show. Furthermore, the IMF too quickly
dismissed the problems associated with the management of large capital flows concentrating
on the arguments on the benefits of liberalization and the ineffectiveness of capital controls
while underestimating the institutional pre-requisites required managing international
financial liberalization, including domestic financial sector reforms. Although after the
Mexican crisis the IMF started devoting more attention to issues such as prudential regulation
and supervisory frameworks, it was only at the end of the 1990s, as a consequence of the
Asian crisis, that the IMF developed a new conception of liberalization that integrates the
domestic financial system and prudential regulation as a key to successful international
integration and as a cushion against crises (Ishii et al., 2002; Karacadag et al., 2003).
This paper is organised as follows. The following section reviews the major
liberalization steps that contributed to the transformation of the Mexican economy and
introduces the IMF’s position on the issue of international financial liberalization. Section II
traces the path that led Mexico towards the 1994 crisis. Section III brings to the surface the
IMF’s interpretation of the financial crisis and, specifically, how the IMF interpreted the
crisis in a way that confirmed its economic ideas on financial liberalization. The last Section
concludes by summarizing the empirical findings and reflecting on the evolution of IMF’s
approach to financial liberalization in emerging market countries at the end of the 1990s and
in response to the subprime crisis. Although it is certainly premature to draw firm
conclusions on Fund’s thinking on capital issues, the comparison between the IMF’s position
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in Mexico and the position on financial liberalization today reveals that the IMF has been
gradually edging towards an acceptance of the view that capital controls may help countries
manage the macroeconomic effects of large capital inflows and that there is no a ready-made
policy toolkit at the disposal of national authorities. Rather, the policy response to large
capital flows should be tailored on each county’s specific circumstances, including the stage
of development of domestic institutions in governing the liberalization process.
I. Mexican financial liberalization and the Fund’s approach to financial liberalization
Analyzing the state of the Mexican economy from the perspective of the early 1990s, it was
hardly disputable that the country had embarked on a ‘significant transformation process’, as
the Secretary of Finance Pedro Aspe Armella put it (1995, p. 127; also Lustig, 1995). By that
time, Mexico had reduced its inflation to the lowest rate in 21 years and recorded GDP
growth at an average rate of around 2.5% in real terms from 1989 to 1994. The public sector
deficit had been also significantly curtailed and major structural reforms were carried out,
including a tax reform, the privatization of important public sector enterprises, and the
allocation of an independent status to the central bank. Several reforms also contribute to
domestic financial liberalization, including the elimination of credit controls, reserve
requirements, interest rate ceilings, and directed lending. The government also proceeded to
privatize a number of commercial banks and lifted the limits on the amount of commercial
paper and corporate bonds that firms could issue. These reforms proceeded in lockstep with
an outward-looking orientation based on financial and trade liberalization.
After an initial opposition to accelerate liberalization voiced by the President Miguel
de la Madrid, who came to power on December 1982, the Mexican presidency became a
prominent sponsor of the benefits of international economic integration (Haber, et al., 2008).
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At the same time, the view according to which trade and financial liberalization was desirable
and appropriate course of economic policy became widespread among domestic political and
business elites who participated to political life in key government positions, contributing to
forge open national economic policies (Feinberg, 1992, Schneider, 1997).2
As a result, starting in 1989, restrictions on financial transaction were significantly
lifted, including the removal of restrictions on the purchase of stocks and government bonds
by foreigners, on the opening of bank accounts and on foreign direct investments (FDI). In
May 1994, the country joined the Organization for Economic Cooperation and Development
(OECD), that is, the organization of the most advanced economies in the world. Becoming a
member, Mexico accepted, among others, the obligation to implement the 1961 Code for the
Liberalization of Capital Movements. Specifically, the Code set an obligation for member
countries to ‘progressively abolish between one another’ restrictions on the movements of
capital ‘to the extent necessary for effective economic cooperation’ (Art. 1a).
As these developments indicate, ‘Mexico went from being a very closed economy to
one of the most open in the world’ (Tornell and Martínez, 2003, p. 41). Against this
background, the renewed confidence of international investors in the economic outlook of the
country translated into a dramatic increase of private capital flows. In a single year, 1993,
Mexico received $31 billion of capital inflows, which amounted to 45 percent of the total
inflows to Latin America, 8 percent of its GDP. Following the signing of the North America
Free Trade Agreement (NAFTA) in January 1994, which created a free-market area between
Canada, Mexico, and the United States, the Mexican stock market boomed, reflecting
markets perception that the agreement would improve corporate performance in the country
and that Mexico’s macroeconomic policies and outward orientation were unlikely to be
reversed. As Pedro Aspe Armella (1995, p. 131) put it,
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Mexico … shifted from a situation of transferring
considerable amounts of resources to the rest of the world
to being a net recipient of foreign capital.
Mexico quickly became a role model for the international community and the ‘benchmark’
for other middle-income countries’ performance (IMF, 1995a, p. 2, 36). Visiting Mexico City
in February 1994, U.S. Treasury Secretary, Lloyd Bentsen, was reported having said that
Mexico’s policies are ‘an example for all of Latin America.’3 In the words of two economists,
‘before December 1994, Mexico was hailed as the prime example of success of marketoriented reforms. It was widely believed that … the country was poised for ascending to a
sustainable high-growth, low-inflation equilibrium. …. the strength of the country’s
fundamentals was rarely questioned’ (Calvo and Mendoza, 1996, p. 170).
The positive assessment of the Mexican economic choices and performance was
widely shared by the IMF where its Managing Director Michel Camdessus (1995b) publicly
pointed at Mexico as a ‘remarkable success on many fronts … an inspiration for many
countries’. Even after the crisis, the voice coming from the IMF defined Mexico as ‘one of
the most successful developing economies’ whose success could be attributed to ‘its
increased openness to the world economy and integration into financial markets’ (Camdessus,
1995b). The IMF’s view of the Mexican economy can be better understood against the
Fund’s approach to financial liberalization that characterized the organization in the early
1990s.
Indeed, concomitant at the debate on the Washington consensus, the debate within the
IMF led the organization to embrace a favourable view of capital account liberalization (IEO,
2005, Leiteritz and Moschella, 2010). In particular, as the analysis of IMF publications and
archival documents reveals, in the early 1990s, the IMF’s view on capital account
liberalization was shaped around some specific propositions related to the benefits of
liberalization and the ineffectiveness of capital controls on both inflows and outflows.
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On the one hand, financial liberalization was conceived as a desirable economic
policy because of its positive impact on member countries’ economic prospects. Specifically,
IMF staff maintained that liberalization was beneficial as a mechanism of economic growth
(welfare-enhancing argument) and as a mechanism to enforce sustainable economic policies
(discipline argument). In other words, the reasoning within the Fund was that the free
movement of capital flows would have led to an efficient allocation of capital and
diversification of risk. Augmenting domestic savings, the transfer of capital to its most
productive use would have boosted investments and economic growth thereby benefiting
individual countries as well as the world economy. The public stance of the IMF in the early
1990s leaves few doubts that seen from 19th street in Washington the benefits associated with
the liberalization of capital flows were substantial. ‘The globalization of financial markets is
a very positive development,’ former Managing Director Michel Camdessus (1995c)
forcefully and repeatedly argued, depicting capital flows as ‘one of the driving forces of
global growth in recent years.’ The IMF’s policies became also progressively informed on the
principle of capital mobility. For instance, until the late 1990s, ‘the Fund … tended […] to
welcome members’ actions taken to liberalize capital account transactions’, while it
‘generally discouraged’ the tightening of capital controls.4
On the other hand, the Fund systematically argued that capital controls, including
market-based controls, were no longer an effective tool for policy makers to avoid
overheating and vulnerability to crises because of their increasing costs and ineffectiveness.
For one thing, in an environment in which the liberalization of current account transactions
was a reality, the opportunity to circumvent controls abounded, thereby raising the costs of
administering and enforcing those controls. For the other, numerous theoretical studies and
empirical observations lent substantial support to the hypothesis that capital controls were
becoming increasingly ineffective, especially in the long-run.5 For instance, drawing on the
9
data of a large panel of developing countries’ experience with capital account liberalization,
staff documented that capital flight is likely to occur the introduction of capital controls
notwithstanding.6 The experience of those countries that resorted to controls during the 1993
Exchange Rate Mechanism (ERM) crisis is illustrative here. Indeed, from the Fund’s
perspective, the temporary controls imposed by Ireland and Portugal on short-term capital
flows during the crisis proved ineffective in the reducing the speculative pressures on their
currencies (Quirk, et al., 1995, p. 12). Next to their ineffectivess, capital controls were also
viewed as damaging in that ‘they may discourage longer-term portfolio and direct investment
flows’ and spill over to other countries.7 In essence, the mainstream view inside the Fund
conceived of capital liberalization as the ‘first best’ solution. ‘The rapid integration of capital
markets has shifted the balance of costs and benefits away from the controls.’8
Although the emphasis was on the question of whether countries have to choose
international liberalization, the IMF also devoted attention to the question of how member
countries should manage such a liberalization. That is to say, although the debate inside the
IMF was primarily focused on unveiling the benefits of global financial integration,
discussions were also conducted on the set of policies that national authorities were required
to adopt in order to reap the presumed benefits. In this connection, primary attention was
devoted to the macroeconomic toolkit member countries could use to manage the
consequences of large capital inflows, including inflationary pressures and asset bubbles.
Specifically, the IMF showed a preference for the use of fiscal policy over monetary policy.
In the words of the staff, for instance, a successful international financial liberalization should
be based on ‘a strengthened capacity to adapt fiscal policy so as to keep resource pressures
from arising when private demands mount.’ Interestingly, then, at that time, the choice of the
exchange rate was not deemed as a key factor in the choice of whether to choose international
financial liberalization.9
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Next to the macroeconomic prerequisites, the IMF also reflected on the role that
structural reforms and their sequencing could exert on capital account liberalization. For
instance, reviewing the experience of developing countries with capital account liberalization,
the IMF staff recognized that ‘opening of the capital account could increase the risks for
banks, through the impact of increased volumes of capital flows on the deposit base, and a
possible increase in exchange rate volatility on banks’ open foreign currency positions.
Capital account liberalization therefore required strengthened supervision related to foreign
exchange risks, generally undertaken as part of a broad process of ongoing financial sector
reforms.’10 In this connection, prudential regulation and sound supervisory frameworks were
recognized a key role in the path to international financial opening.
For instance, in one of the early 1990s staff memoranda, IMF staff noted that ‘freeing
capital account transactions should be undertaken subsequent to, or at least broadly
simultaneously with, certain other reforms.’ Among them, ‘the most important [to successful
capital account liberalization were] domestic financial market reforms’ including
‘strengthening prudential regulations and requirements’ especially where there is a large
government deposit insurance, or where there is a presumption that large banks will not be
permitted to fail. Under these circumstances, indeed, IMF staff noted that there might be
‘incentives for banks to take on excessive risk, and capital account liberalization could open
up further high-risk opportunities for depository institutions’.11
In spite of the theoretical awareness on the risks to the success of international financial
liberalization coming from domestic financial vulnerabilities, the IMF did not really elaborate
and act on them. As the Independent Evaluation Office (2005, p. 4) report on the IMF’s
approach to financial liberalization in the early 1990s noted, although the Fund
‘acknowledged the need for a sound financial system in order to minimize the risks of
liberalization’, its advice to member countries ‘largely remained at the conceptual level and
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did not lead to operational advice on preconditions, pace, and sequencing until later in the
1990s’. This point is further illustrated in the results of one of the internal reviews of Fund
treatment of capital issues in developing countries. Indeed, the review of the Article IV
consultations during 1993-95 between the IMF and a group of countries (including
Argentina, Botswana, Indonesia, Korea, Malaysia, Mexico, Thailand, and Venezuela) reveals
that the IMF’s support to liberalization derived from its assessment of the macroeconomic
outlook rather than from the analysis of the stage of domestic financial development.12 That
is to say, the Fund encouraged liberalization when appropriate fiscal, monetary, and exchange
rate policies where deemed to be in place and in the presence of current account surpluses.
The assessment of the domestic financial system, in contrast, only played a marginal role in
the Fund’s support to liberalization across its membership.
As the next sections are going to show, the IMF interpreted the trajectory of the
Mexican economy through the lens of its economic ideas on capital account liberalization as
reviewed thus far. Hence, even in the aftermath of the 1994 Mexican crisis, the IMF pointed
at Mexico to demonstrate the positive effects of financial liberalization on economic growth
and the ineffectiveness of capital controls as a way to manage large capital inflows and
outflows. The assessment of domestic financial vulnerabilities, in contrast, was less
prominent, although the IMF started properly incorporating financial sectors issues in its
analysis in the aftermath of the crisis.
II. Heading towards the Financial Crisis
While contributing to its economic development, the liberalization of international capital
transactions also made the country more vulnerable than before. The crisis that burst in the
late 1994 well illustrates this point. Indeed, the crisis was marked by a sharp reversal in
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market sentiment that led to large capital outflows from the country. ‘After the devaluation,’
Guillermo Ortiz the then Mexican Finance Minister commented, ‘financial markets for
Mexico virtually disappeared, and there was a true stampede, in which all Mexican public
and private debt instruments were literally thrown out’ (as quoted in Calvo and Mendoza,
1996, p. 173).
Some have argued that Mexico could have avoided the tequila crisis had it not
liberalized its financial markets so fast (Sachs, et al., 1996). Others claim that it was not
liberalization but the lack of structural reform and Mexico’s credit crunch that exacerbated
the effects of the crisis (Tornell and Martínez, 2003). Still, other scholars have identified the
causes of the peso devaluation in the inappropriateness of Mexican monetary and fiscal
policies during 1994 (Lustig, 1995). In other words, there is substantial controversy about
what led Mexico towards the crisis and whether capital account liberalization was one of the
main culprits. In order to assess what went wrong, it is therefore necessary to first review the
events that led to the crisis.
In spite of the efforts in stabilization and structural adjustment described above, from
the beginning of the 1990s, the Mexican economy started revealing key weaknesses. The
current account deficit deteriorated sharply, widening from about 5% of GDP during the
period 1990-1993 to more than 8% in 1994. The deficit was further complicated by the
overvaluation of the Mexican peso, with the real exchange rate appreciating 35% from 1990
to February 1994 (IMF, 1995a, p. 54). In addition, GDP growth slowed, recording a
disappointing 0.6% in 1993 (IMF, 1995b, p. 92). In spite of this worsening outlook, until
March 1994 there were no signs of public concern13 also because the deficit was securely
financed by large capital inflows and the interest rate required by foreign investors on
Mexican securities was relatively low – especially, in the immediate aftermath of the signing
of NAFTA.
13
In a replication of the 1980s script, however, both external and internal shocks
severely stressed Mexico’s economic fundamentals. On the external front, since February
1994, the Federal Reserve raised the federal funds rate from 3 percent to 5.5 percent by end
of November, making Mexico’ borrowing from international capital markets more expensive
and exacerbating the current account deficit. On the internal front, a series of political shocks,
including the assassination of the then-ruling Institutional Revolutionary Party (PRI)
presidential candidate Louis Donaldo Colosio, raised concerns among market participants
about the country’s political stability and economic commitments. Against this backdrop, the
Mexican stock and bond markets came under selling pressures, with the spreads on Mexico’s
Brady bonds over comparable U.S. Treasury bills beginning to widen – reflecting investors’
expectation that the exchange rate policy would likely be abandoned.
The government initial reaction was first and foremost a public pledge not to
devalue.14 Nevertheless, the response was not a conventional policy of high interest rates to
repel the speculative attack against the currency. Instead, the central bank kept interest rates
down by expanding domestic credit – primarily providing credit to the banking sector and
purchasing government securities held by private sector. The authorities’ crisis response was
mainly motivated by domestic factors. Specifically, the fragility of Mexican banking sector
discouraged the central bank from tightening interest rates. In its 1995 Monetary Program, for
instance, the central bank justified its policy arguing that doing otherwise ‘would have
affected debtors, including financial intermediaries, in a highly unfavourable way’, that is, it
would have caused banking bankruptcies and failures (as quoted in Sachs, et al., 1996, p. 35).
Furthermore, the political cycle was not favourable to the adoption of an unpopular policy
such as high interest rates: presidential elections were indeed scheduled to be held in August.
Given the choice not to raise interest rates, Mexican public commitment to maintain
the value of the peso took the form of an offer to exchange short-term (Cetes) and long-term
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peso-denominated bonds with short-term dollar-denominated bonds (Tesobonos). The
problem was that if the country had come under selling pressure, the central bank could not
resort to printing money to meet government obligations coming due and even devaluation
would not have helped.
The transformation of government debt into foreign currency-denominated debt met
with the enthusiasm of financial markets. Since the government was committing itself to
repay in foreign currency, it was unlikely that it would renege on its promises. As a result, the
stock of tesobonos grew rapidly, contributing to the build-up of a threatening short-term
foreign-denominated government debt. Specifically, the stock of outstanding tesobonos grew
tenfold between February and November 1994.15
During the fall, however, outflows resumed following new domestic political
shocks.16 In the meantime, with an increasing stock of tesobonos falling due, the gap between
government foreign-denominated liabilities and foreign reserves grew large. In the threemonth period of September through November, the stock of reserves depleted to around $13
billion – almost half the stock of reserves recorded at the end of 1993. 17 By mid December,
rumours surrounding Mexico’s imminent devaluation gained strength fuelling increasing
market pressures.
Mexico was forced to devalue on December 20, 1994 – by widening of 15 percent the
exchange rate band. During the course of the trading day on December 20, the peso lost an
immediate 3 percent of its value and short-term interest rates spiked. From December 1994 to
March 1995, the peso declined 32 percent against the dollar eventually stabilizing at about
7.5 pesos per dollar— a fall of more than 50 percent since the beginning of the crisis.
According to the data the IMF relied on, during December, there was a net outflow in the
form of foreign holdings of Mexican government securities (including Cetes and Tesobonos)
of about $790 million and a further decline of $6.6 billion in foreign reserves (IMF, 1995a, p.
15
60). With the government unable to roll over its short-term debt, Mexico’s access to
international capital markets was sharply curtailed.
Under exchange market pressures, interest rates rocketed reaching levels as high as
80% in the first quarter of 1995 increasing the number of non-performing loans. Combined
with the domestic financial sector’s large international exposure (as of December 1994, a
third of the total loans made by Mexican banks were denominated in foreign currency), these
developments seriously threatened Mexico’s financial stability. The spread of the crisis to
several emerging market countries also raised doubts on the stability of the international
financial system, forcing an international bail-out. Indeed, on February 1, 1995, the Executive
Board of the IMF approved a $17.8 billion standby loan – the largest ever approved for a
member country, both in the absolute amount and in relation to the country’s quota in the
Fund. The United States contributed an additional $20 billion to the rescue package and the
Bank for International Settlement (BIS) and commercial banks extended $10 and $3 billion
respectively. Both the IMF and the Clinton Administration were harshly criticized for the
support provided to Mexico, and both made a staunch defence of this decision. It is therefore
interesting to explore how the IMF interpreted the Mexican financial crisis in order to justify
what some commentators have defined as the Fund’s ‘extraordinary’ rescue package (Sachs,
et al., 1996, p. 48).
III. The Mexican Crisis from the Outside: The IMF’s View
As an economist put it, ‘when a new crisis hits, the previous generation of models is judged
to have been inadequate’ (Rodrik, 1998, p. 58). The Mexican crisis was no exception. Indeed,
in the aftermath of the crisis, which provided the most vivid example of the speed with which
financial risks can spread across the globe, economists and policy makers started debating
16
about the implications of growing global financial integration.18 Within the IMF, the ‘inhouse reflection’ (Camdessus, 1995d) sparked by the Mexican crisis provided an opportunity
to reflect on the risks of global capital markets and on the policies that member countries
need to pursue in the context of a globalized economy. In interpreting the Mexican crisis,
however, neither the presumption on the benefits deriving from global financial integration
nor the prescription against the use of capital controls went seriously challenged. Rather, the
voice coming from the Fund clearly reaffirmed the belief in the benefits of capital account
liberalization. As Camdessus (1995e) strongly put it in spite of the disruptions caused by the
crisis, the ‘increasing openness to trade and financial flows’ is ‘an essential and reliable basis
of economic progress.’ Bringing this argument forward, he thereby suggested that, rather than
‘forego[ing] the benefits of globalization’, it were ‘policy inadequacies that have to be
addressed’ (Camdessus, 1995a; 1995e).
Pointing to ‘policy inadequacies’ as the main culprit of the Mexican crisis, the IMF
provided an interpretation of the 1994-95 events consistent with the logic of currency crises,
which points to the collision between domestic goals and an unsustainable exchange rate to
explain sudden and massive reversals of capital flows. ‘What happened in Mexico was the
typical crisis of an overvalued currency,’ magnified by the speed of capital outflows typical
of an era of globalized finance (Fischer 1995b). ‘Data on the key economic and financial
variables’, the IMF staff noted in its 1995 International Capital Markets Report (IMF, 1995a,
p. 70), ‘suggest that developments in Mexico surrounding the devaluation were consistent
with the classic properties of a speculative attack.’
In other words, the sharp reversal of capital flows that Mexico experienced was
attributed to its weak fundamentals – both internal and external imbalances. As stressed by
Camdessus (1995a, 1995f), Mexico suffered from severe macroeconomic ‘shortcomings’ that
can ‘be traced in large part to the widening of its external current account deficit … and also
17
to an insufficiently tight domestic monetary policy.’ Hence, the incompatibility between
domestic macroeconomic policies and exchange rate policy drove investors to think, with
some reason, that the peso might be devalued thereby making them unwilling to hold
Mexican financial assets.19 In other words, from the IMF’s perspective, the crisis confirmed
the importance of sound macroeconomic policies as the key to successful international
financial liberalization and therefore as a basis for the Fund to encourage liberalization across
its members. This conclusion was further corroborated by way of comparison between
Mexico and the economic performance of those countries that suffered from the tequila
effects. According to the IMF staff World Economic Outlook (1995b, p. 6), for instance,
‘countries with a stronger saving performance … [were] generally less vulnerable to shifts in
market sentiment, although they have not been immune to contagion effects from the crisis in
Mexico’.
Conceived in these terms, the peso crisis was not interpreted as an instance of market
pathology or speculative bubble. The voice coming from the IMF lent support to the view
that the Mexican crisis may well be considered as an instance of the market rational response
to perceived inconsistencies in economic policies (IMF, 1995a, p. 70). From the Fund’s
perspective, investors came to believe that the fixed exchange rate policy would eventually be
abandoned. Hence, in an attempt to anticipate profits and losses, investors reacted by
restructuring their portfolios, a move that ultimately speeded up the collapse of the peso
exchange rate. In short, the prevalent view was that ‘markets are not always right, but they
are often appropriately discriminating’ (Camdessus, 1995a). As Stanley Fischer (1997)
emphasized, ‘currency crises do not blow up out of a clear blue sky, but rather start as
rational reactions to policy mistakes or external shocks.’ Having emphasised its domestic
policy mistakes, Mexico thereby provided an apt example to prove the rationality of market
discipline.
18
From the IMF’s perspective, then, the crisis also provided further evidence on the
ineffectiveness of capital controls as a way to manage large capital flows. In particular, while
the IMF praised Argentinean efforts not to impose controls to stem the contagion effects, 20
the Fund forcefully condemned the use of capital controls in Brazil. As Camdessus (1995b)
emphatically commented, Argentina, by ‘defending the exchange rate by strengthening fiscal
policy and avoiding recourse to capital controls, Argentina showed that it was possible to
harness the risks of global financial integration.’ In contrast, archival documents reveal that
the IMF criticized Brazil’s use of capital controls on both inflows and outflows in response to
the crisis. In the words of IMF staff, ‘although [controls] can provide useful breathing room
for the formulation of more fundamental measures, they create distortions and tend to lose
effectiveness over time.’21
Significant as these continuities in the Fund thinking are, they should not obscure
some important discontinuity in the Fund’s approach to international liberalization as
compared to the recent past. In particular, the IMF started attributing increasing importance
to financial sector issues as part of the re-requisites deemed necessary to successful
management of global financial integration. As we have seen in the previous section, until the
mid-1990s, the reviews of the Fund’s advice to its countries in the context of its surveillance
activities reveal that domestic prudential regulations and supervisory frameworks, for
instance, did not figure prominently in the IMF’s assessment of national economies aiming at
suggesting international financial liberalization. In the aftermath of the crisis, however, the
Fund started paying increasing attention to financial sector issues incorporating them, for
instance, in the conduct of Fund surveillance. Indeed, as one of the reviews of the Fund
surveillance put it, the Fund’s systematic and intensive involvement with financial sector
issues can be traced back to the Mexican, and later, to the Asian crises (Gola and Spadafora
2009, p. 3). This is not to say that after the crisis the IMF dramatically shifted its focus to the
19
domestic financial prerequisites to liberalization. Rather, what the crisis brought about was a
strong recognition of the importance of domestic financial development for international
opening that, however, was not accompanied by a clear-cut change in the IMF’s practice. A
1997 staff memorandum that discussed the modalities of capital account liberalization well
summarises the Fund’s new awareness on domestic financial prerequisites. In the words of
the memorandum, ‘the staff seemed cautious about aggressively pursuing the promotion of
capital account convertibility and appeared mindful of the importance of a sound,
competitive, and well supervised domestic financial system’.22 In spite of such a mindedness,
however, the review of IMF’s advice on capital liberalization in a number of countries
reveals that the IMF still predominantly relied on an analysis of policy fundamentals whereas
the analysis of the domestic financials sector only played a marginal role, as the IMF’s
encouragement to liberalization in Korea and South Africa reveals.23
In conclusion, the Mexican crisis, which had ‘certainly demonstrate[d] the power of
the international capital markets’ (Fischer, 1995), left most of the tenets of the Fund’s
approach to capital liberalization intact. The predominant view was still that the free
movement of private capital flows should be relied on to attain economic growth and to
impose macroeconomic discipline and that sound macroeconomic policies were key to
successful liberalization. Even though the crisis provided a powerful image of the scale and
volatility of capital flows in a globalized world, the IMF did not embrace the principle of
capital controls, neither as an instrument to prevent nor as a mechanism to manage crises.
Within such a remarkable continuity in thinking, the IMF also started reassessing the
importance of domestic financial sector policies as key to successful international
liberalization. These insights, however, did not bring about any significant transformation in
the way the Fund assessed the economies of its members in order to suggest whether or not to
open the capital account.
20
V. Conclusions
During the last several months, we have witnessed one of the most trying times for financial
markets in several decades. The subprime crisis, which burst in the U.S. credit markets but
propagated to the entire world, has shown, as several other times in the recent past, the risks
associated with closely integrated capital markets. Indeed, although it originated in the
industrialized world, the crisis hardly hit emerging market countries too. In this connection,
the channel of finance, along with that of trade, has proved crucial in spreading the contagion.
This is well exemplified by the contagion that took place in Central and Eastern Europe. In
these countries, the transition from a planned to a market economy has resulted in a rapid and
near-complete openness to trade and foreign capital. Such an opening was accompanied by
large capital inflows that have fuelled unsustainable credit booms primarily through the
banking sector. When the crisis hit, however, foreign capital massively abandoned the region
pushing the domestic economies into recession. However, the return of capital flows in the
late 2009, not only in Central and Eastern Europe but in most emerging markets, has raised a
new set of challenges including that of inflation and asset bubbles. The crisis has thereby
raised old and new issues regarding the benefits of capital liberalization for middle-income
countries and about the appropriate policy toolkit national authorities should use to manage
large capital inflows.
This paper has addressed this issue by looking back at the 1990s. In particular, the
paper has analyzed the economic trajectory of a country, i.e. Mexico, which, from the early
1990s to the burst of the crisis in 1994, had adopted important financial liberalization reforms
at both the domestic and the international level and which, like most of Central and Eastern
European countries in 2007-08, had accumulated large foreign exposures – as already noted,
as of December 1994, a third of the total loans made by Mexican banks were denominated in
21
foreign currency. Analyzing the Mexican economic trajectory, the paper focused on the
decision to open the capital account and the policies used to manage such an opening by
providing the perspective of the IMF on these issues. What the analysis reveals is that the
Fund supported the choice of international financial liberalization and interpreted the crisis
that burst in Mexico in 1994 based on the assessment of the country’s macroeconomic
outlook and management. Domestic financial sector conditions, in contrast, contributed less
in forging the IMF’s stance. Indeed, in the early 1990s, the IMF mainly focused on the issue
of whether capital account liberalization was beneficial – answering in the affirmative and
thereby undermining the case for the use of capital controls. In contrast, the debate on how
such benefits could be grasped, that is to say, the question about the policies that were
required to manage international liberalization, including domestic financial sector reforms,
did not translate into the Fund’s operational practice.
Since the Mexican crisis, many changes have taken place in the Fund approach to
financial liberalization, primarily as a response to the 1997-8 Asian crisis which vividly
showed the macroeconomic implications of the increasing globalization of capital markets
and of financial sector vulnerabilities. Specifically, after 1998, the IMF’s focus started
questioning the benefits of capital account liberalization (Prasad et al., 2003) and rethinking
the use of capital controls. To start with, whereas at the beginning of the 1990s, the voice
coming from the IMF emphasized the direct linkage between the volume of capital flows and
economic growth, at the end of the decade, the benefits of liberalization started being
regarded as indirect. That is to say, the benefits that capital flows bring about do not
materialize directly through the provision of capital for domestic investments but they are
mediated through the domestic financial system. For instance, a study conducted by a team of
the IMF Research Department, found that ‘far more important than the direct growth effects
of access to more capital is how capital flows generate a number of …’potential collateral
22
benefits’’ (Kose, et al., 2006, p. 8). These ‘collateral’ benefits include a strengthened
domestic financial market, good governance, and market discipline. Given the importance of
the domestic financial system as a mediating factor, increasing importance has been placed,
on the sequence of the liberalization process and on financial sector policies in particular
(Ishii et al., 2002; Karacadag et al., 2003). As succinctly put in a staff memorandum,
‘regardless of the pace, successful liberalizations have required complementary financial
sector reforms’.24 Furthermore, the IMF also started taking on a less doctrinaire view against
the use of capital controls. This is well illustrated in the new IMF’s assessment of marketbased controls on capital inflows whose use had been stigmatized in the first half of the
1990s. Indeed, although this type of controls was still regarded as ineffective and
distortionary in the long run (IMF, 2007, Ch. 3), the IMF ceased regarding them ‘as
incompatible with the still-desirable goal of capital account liberalization.’25
The evolution in the Fund’s thinking seems continuing in the aftermath of the
subprime crisis. In particular, the IMF has intervened in the debate on the policies national
authorities in emerging market countries can use to manage large capital inflows. In this
connection, the IMF has identified a number of policy options including appreciation of the
exchange rate, fiscal retrenchment, and accumulation of foreign reserves (IMF, 2010, Ch.4)
Interestingly, prudential regulation figures prominently in the list of policy options ‘with both
microprudential and macroprudential objectives’ (IMF, 2010, p. 7). That is to say, prudential
measures such as liquidity and capital ratios can help financial institutions in mitigating the
risks associated with large capital inflows. As far as concerns the use of capital controls, there
are mixed signs on the topic. On the one hand, the IMF has depicted them as ‘a useful
element in the policy toolkit’, provided that ‘the available policy options and prudential
measures do not appear to be sufficient or cannot provide a timely response to an abrupt or
large increase in capital inflows’ (IMF, 2010, p. 8). This position has been reinforced by the
23
Managing Director Dominique Strauss-Khan affirmed that ‘there is no reason to believe that
no kind of control is always the best kind of situation’ (as reported in Guha, 2009). On the
other hand, however, the IMF still strongly doubt on the effectiveness of controls. As the IMF
concludes in the April 2010 Global Financial Stability Report, ‘while controls are generally
associated with a decrease of inflows and a lengthening of [investment] maturities, these
results are statistically significant in only a few cases.’ In other words, capital controls did not
appear able to reduce the overall volume of inflows. Furthermore, controls ‘are rarely
successful in dampening exchange rate appreciation’ (IMF, 2010, p. 12-3).
In conclusion, the Fund approach to financial liberalization has evolved slowly and
reactively, that is to say, mainly in reaction to major financial disruptions. In particular,
important differences emerge from the comparison between the Fund’s insights developed in
the aftermath of the Asian and subprime crisis and the Fund’s position in the early 1990s.
Indeed, the Fund has moved from a position positing the general benefits of international
financial liberalization to a more complex position where the benefits are still acknowledged
but their realization is deemed to be conditional on a number of structural and not solely
macroeconomic reforms. In this connection, the Fund has shifted its emphasis on domestic
financial sector reforms and their sequencing, although such prescriptions have not been
systematically applied as the many problems in domestic financial regulation brought to the
surface by the subprime crisis have vividly demonstrated. While controls are still largely
regarded as ineffective to stem the macroeconomic consequences of large capital inflows, the
Fund is nonetheless less categorical in its position against their use. That is to say, the Fund
acknowledges the possibility that inflows controls can be part of the policy toolkit to manage
global financial integration.
24
Endnotes
1
For instance, Brazil imposed a 2 percentage tax on foreign purchases of equities and bonds in October 2009.
Peru signalled it might have limited foreign exchange exposure of its banks as part of an effort to reduce
currency volatility.
2
In what follows, I exclusively focus on the reforms adopted to achieve international financial liberalization,
bracketing those reforms aiming at achieving trade liberalization.
Jeffrey R. Smith and Clay Chandler, ‘Peso Crisis Caught U.S. By Surprise,’ The Washington Post, February
3
13, 1995.
4
IMF Archives, SM/95/164. Capital Account Convertibility: Review of Experience and Implications for Fund
Policies. July 7, 1995, p. 8, 10
5
IMF Archives, SM/95/164, Sup. 1. Capital Account Convertibility - Review of Experience and Implications
for Fund Policies - Background Paper. July 10, 1995, p. 7-9; 17.
6
IMF Archives, SM/95/164, Sup. 1, p. 7-9; p. 17.
7
IMF Archives, SM/94/202. Issues and Developments in the International Exchange and Payments Systems.
August 1, 1994, p. 20.
8
Ibid., p. 25
9
IMF Archives. SM/95/164, p. 3, 4.
10
IMF Archives. SM/95/164, Sup. 1, p. 11
11
IMF Archives. SM/95/164, p. 3, 4.
12
IMF Archives. SM/95/164, Sup. 1, p. 21-3.
13
A notable exception is provided by Rudiger Dornbusch who issued early warnings on the danger of the
Mexican economy Rudiger Dornbusch and Alejandro Werner, ‘Mexico: Stabilization, Reform, and No Growth’
(Brookings Paper on Economic Activity, Issue 1: 253-315, Brookings Institution, 1994).
14
Before the devaluation, the peso-dollar exchange rate was allowed to fluctuate within a band consisting of a
fixed lower limit (on the peso appreciation) and an upper limit that increased by MexN$0.0004 a day.
15
If not otherwise specified, economic data used in this section are drawn from the International Capital Market
Report (August 1995), chapter II (p. 2-11) and background papers II and III (p. 53-78).
16
Deputy Attorney General Mario Ruiz Massieu resigned denouncing the government for an attempt to block
the investigations on the assassination of his brother, Ruiz Massieu
25
17
Note should be taken that capital flight was not led by foreign investors. Domestic investors were the first to
send their funds abroad, offering ‘a useful remainder that with increasingly liberalized and integrated capital
markets, domestic investors also have the potential to initiate a crisis’. Morris Goldstein and Guillermo A.
Calvo, ‘What Role for the Official Sector?,’ in Private Capital Flows to Emerging Markets after the Mexican
Crisis, ed. Guillermo A. Calvo, Morris Goldstein, and Eduard Hochreiter (Washington, D.C.: Institute for
International Economics and Vienna, Austria: Austrian National Bank, 1996).
18
The Mexican crisis, indeed, sparked a debate about the reforms to the international financial architecture and,
in particular, to the workings of the international financial institutions. See, for instance, G7, Ministers of the
Group of Seven. Halifax Summit Communiqué, June 16, 1995.
19
In the 1995 International Capital Market Report, however, IMF staff conceded that the Mexican crisis did not
fully fit with the speculative attack hypothesis because of two factors. First, reserve losses were not depleted as
a reflection of expansionary policies. Second, the real exchange rate appreciation was not an immediate
problem. Even in the presence of such ‘variations’ from the standard speculative attack model, the staff
nonetheless pointed to weak fundamentals to explain the currency attack on the peso. IMF, International Capital
Markets: Developments, Prospects, and Key Policy Issues, Washington, D.C.: International Monetary Fund,
1995a, p. 70, 74
20
Indeed, in line with the IMF’s financial orthodoxy, Argentina avoided recourse to capital controls on capital
outflows but tightened its fiscal policy, cutting government expenditure. It also privatized provincial banks and
provided liquidity support for the banking system. Also, IMF Archives, SM/97/32 Supplement 1. Review of
Experience with Capital Account Liberalization and Strengthened Procedures Adopted by the Fund. February 6,
1997, p. 34.
21
IMF Archives, SM/97/32 Supplement 1, p. 34
22
IMF Archives, SM/97/32 Supplement 1, p. 37, emphasis mine.
23
IMF Archives, SM/97/32, Capital Account Convertibility and the Role of the Fund-Review of Experience and
Consideration of a Possible Amendment of the Articles. February 5, 1997, pp. 37-40.
24
IMF Archives. SM/99/60. Countries’ Experiences With the Use of Controls on Capital Movements and
Issues in Their Orderly Liberalization. 5 March 1999, pp. 6.
25
IMF Archives. SM/98/187. Theoretical and Practical Aspects of Capital Account Liberalization. 17 July
1998, pp. 49.
26
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