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December 1, 1994 eCONOMIC GOMMeiMTCIRY Federal Reserve Bank of Cleveland How Important Are U.S. Capital Flows into Mexico? by William P. Osterberg I n November 1993, the U.S. Congress voted to pass the North American Free to the list of countries with which our nation runs a trade deficit: Overall, we Predictions of the effects of removing Trade Agreement (NAFTA) after borrow from most of the rest of the barriers on trade, employment, and months of heated debate about its likely world. Second, I discuss evidence output between Mexico and the impact on our economy. As a result of regarding the causation of capital flows United States were abundant follow- the intense focus on this issue, the public and the implications for the Mexican ing passage of the North American has benefited from a greater appreciation economy. A key conclusion is that fac- Free Trade Agreement in late 1993. of the increased interdependence of the tors external to Mexico have important Missing from much of the dialogue, Mexican and U.S. economies. However, influences on capital movements. however, was emphasis on the impor- both the public debate and detailed Finally, I discuss some of the possible tance of capital flows from the United analysis of the post-NAFTA economic Mexican policy responses to capital States into Mexico. The Mexican cen- environment have understated the flows and how they might affect trade tral bank's response to fluctuations in importance of capital flows from the flows between the two nations. A key these capital flows could alter the United States into Mexico. decision of the Mexican central bank trade balance, with important impli- involves the use of partially sterilized cations for output and employment. Most observers agree that Mexico's trade intervention to respond to shifts in capi- deficit with our nation implies Mexican tal flows that are caused by outside de- borrowing. Unfortunately, predictions of velopments.1 It appears that forecasts of the post-NAFTA environment often the post-NAFTA trade flows between emphasize the effects of the removal of Mexico and the United States could eas- trade barriers on trade, employment, and ily be confounded by a combination of output and assume that the necessary developments in international capital borrowing will somehow materialize. markets and Mexican policy decisions. Few studies point out that although changes in the trade balance may be sup- • Accounting for Recent ported by capital flows, it is also possible U.S.-Mexico Trade Flows that fluctuations in capital flows and the Most analyses of U.S.-Mexico trade Mexican policy response to such flows have focused on merchandise trade could alter the trade balance and thus (such as agricultural products and affect output and employment. machinery), which is clearly much more important to Mexico than to our nation. This Economic Commentary details the Since January 1993, the United States role of capital flows from the United has enjoyed merchandise trade surpluses States to Mexico for the post-NAFTA averaging $232 million per month (see period. First, I contrast recent data on the figure I). 2 Although Mexico is a strik- bilateral exports and imports of goods ingly large exception to the list of coun- and services with data on capital move- tries with which we run a merchandise ments. Mexico is an important exception trade deficit, exports to Mexico account- ed for only 6 percent of total U.S. ex- CAPITAL FLOWS IN THE WAKE OF NAFTA ports in 1993:IVQ and amounted to only Much analysis of the post-NAFTA environment is influenced by economic stud- 1 percent of U.S. gross domestic product ies of NAFTA itself. Although varied in their approaches, such studies generally (GDP).3 Mexico's trade dependence on pay less attention to capital flows than to trade, output, and employment. They us is far greater: Shipments to the United often either assume that the capital flows required by trade predictions will States were 78 percent of its total exports somehow materialize, or they predict capital flows based on the experience of and 10 percent of its GDP, while imports other countries. Moreover, a Congressional Budget Office (CBO) assessment from the United States were 69 percent notes that"... most of the models... assume that the respective capital stocks of of its total imports.4 the United States and Mexico would be unaffected by NAFTA" and that they thus ignore the potential long-term impact of increased capital flows.a Only A less recognized fact is that capital one 1993 study made an explicit prediction of capital flows, and it significantly flows from the United States into Mexico underestimated them.b are significant. Net capital flows are Analyses that ignore the long-run impact of capital inflows on the Mexican capi- more closely related to the balance on tal stock (mainly equipment and factories) probably predict too high a level of in- current account (BCA, as shown in fig- terest rates (since the marginal productivity of capital would fall with higher cap- ure 2) between the two countries than to ital) and too low a level of wages. The larger stock of capital would permit higher the merchandise trade balance. The BCA output and income. The short run, however, is harder to predict, and analyses that is a more comprehensive measure of assume an eventual increase in the capital stock ignore the short-run interactions trade, although it is available less fre- between capital flows and the exchange rate. For example, in the long run, the quently.5 The U.S. BCA with Mexico Mexican BCA deficit could be smaller, lowering the value of the peso, while in became positive in 1991, increased to $5 the short run, in order to facilitate the capital inflows, the peso would be stronger billion in 1992, then dropped sharply in and the BCA deficit larger. Although a stronger peso will help Mexico's fight 1993. As with the merchandise trade bal- against inflation, the adjustment of the Mexican export sector to trade liberaliza- ance, the Mexican-U.S. BCA surplus tion may be made more difficult.0 stands in contrast to the overall U.S. BCA deficit. a. See "Estimating the Effects of NAFTA: An Assessment of the Economic Models and Other Empirical Studies," Congressional Budget Office, June 1993, p. 31. Although the aggregate capital stock is assumed to be unchanged, a shift between expanding and contracting industries is allowed. The connection between the U.S.- b. This study estimated that net capital flows from all countries into Mexico would average between $3 Mexican BCA and bilateral capital billion and $9 billion per year for 10 years. Though the 1992 Mexican BCA deficit with the United flows is indirect, however. Although the States was $5 billion, the IMF estimated the overall Mexican BCA deficit at $22.8 billion. See "A Bud- Mexican BCA deficit with the United getary and Economic Analysis of the North American Free Trade Agreement," Congressional Budget Office, July 1993. This study concludes that"... the effect of NAFTA on capital flows has not been States must be associated with someone analyzed as much as its likely economic significance would appear to justify." (p. 18) acquiring $5 billion of Mexican assets c. See the comments by Robert Z. Lawrence in Nora Lustig, Barry P. Bosworth, and Robert Z. (a capital inflow into Mexico), the Lawrence, eds., North American Free Trade: Assessing the Impact, Washington, D.C.: The Brook- United States is not necessarily the ings Institution, 1992. acquirer. More direct evidence is shown in the annual accounting of net flows of private assets from the United States to It is just as likely that the BCA—and in 1990 of the Brady Plan for Mexico's Mexico (figure 3). In 1993, net U.S. pri- thus the trade flows—are caused by the external bank debt.7 Actual and an- vate assets in Mexico increased by capital flows. As a result, developments nounced policy changes undoubtedly almost $14 billion. Like the BCA, this external to Mexico, such as changes in led the financial markets to anticipate bilateral statistic stands in contrast with international capital markets, may ini- changes in trade flows, but this does not the relation of the United States to the tially affect capital flows and force an automatically imply that the trade flows world as a whole. While capital moves adjustment in the current account. In had to change before capital flowed into from the United States to Mexico, it fact, the experience of the past few years Mexico. A comparison of figures 2 and moves from the world as a whole into confirms that capital flows do not simply 4 shows that although the recent swing the United States. respond to the BCA (see figure 4). The of the U.S. BCA with Mexico toward a monthly volume of gross purchases of surplus has been accompanied by large U.S. capital flows into Mexico are thus volumes of gross capital flows, previous long-term securities between the United not directly related to the fact that the States and Mexico has grown much deficits in the BCA of comparable mag- United States runs a BCA surplus with more sharply than the volume of trade.6 nitude did not follow this pattern. Mexico. However, even if we look at Mexico's BCA deficit and capital The jump in volume in 1990 is widely We have some reason to believe that cap- accounts with the entire world, we can- attributed to an improved investment ital flows can play an independent and not conclude that capital flows are climate brought about by financial liber- significant role in eventually moving the caused by the BCA. alization and income policies enacted in current account, rather than vice versa.8 1988, as well as by the implementation FIGURE 1 U.S. MERCHANDISE TRADE WITH MEXICO Capital flows also appear to be influ- enced by external factors. Although Millions of dollars much economic analysis assumes that 4,500 capital flows respond to interest-rate differentials (so that policies leading to increased Mexican interest rates should draw capital into Mexico), there is evi- dence that this mechanism does a poor job of explaining capital flows into or out of the nation. While Mexican short- term interest rates have been well above U.S. rates since at least 1988, differen- tials have narrowed on average since 1990, a period of high volumes of capi- tal transactions between the two coun- tries. In a detailed econometric study, three authors found that in addition to interest-rate differentials, some external 1983 1984 1985 1986 1987 1989 1990 1991 1992 1993 1994 factors were at work in drawing capital to Latin America: the U.S. recession, NOTE: All data are monthly. the decline in U.S. interest rates, and a SOURCE: U.S. Department of Commerce, Bureau of the Census. sharp swing in the U.S. private capital account.11 FIGURE 2 U.S. BALANCE ON CURRENT ACCOUNT WITH MEXICO • Capital Inflows and Billions of dollars Foreign Exchange Reserves 6 The role of the central bank has been largely ignored in discussions of capital inflows. Central bank decisions on capi- tal flows affect the official reserve ac- count, which measures the central bank's net acquisition of official assets versus that of other central banks. Capital in- flows to Mexico thus do not necessarily translate into greater BCA deficits, as the Bank of Mexico may choose to absorb some of the inflow into its reserves—in effect, determining how much of the cap- ital inflow is allowed to affect exports and imports. If the central bank inter- venes and buys all of the foreign cur- rency pouring into the country, then the 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 foreign exchange reserves of the central SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. bank rise (the official reserve account changes) and the current account is unaf- fected. Or, if the central bank chooses not to intervene, then the capital inflow is One reason is that worldwide develop- data processing, the need to finance reflected in exports and imports and the ments in capital markets may have larger fiscal and current account deficits, current account moves toward a deficit. changed either the magnitude of expect- a desire to hedge against higher volatility ed capital flows or the sensitivity of such of asset prices, and securitization. Latin This latter scenario is subject to two dif- flows to changes in interest rates. One America has been a major destination for ferent interpretations. Suppose an analyst research study finds that international capital flows in the early 1990s. Annual notices that Mexico is importing more capital flows have grown faster than capital flows to Latin America from all than it is exporting (a current account either domestic financial-market activity countries averaged $8 billion during the deficit) and is also borrowing from or the value of world trade.9 Some of the late 1980s, but grew to $24 billion in abroad. One could conclude that Mexico explanations for this conclusion include 1990, $40 billion in 1991, and $53 billion is being forced to borrow to finance its less expensive telecommunications and in 1992.1() "excess" spending. On the other hand, FIGURE 3 NET FLOW OF U.S. PRIVATE ASSETS TO MEXICO and eventually stokes inflation. It could sterilize the rise in the money supply by Billions of dollars 5 selling government securities to remove the pesos from circulation. But although the inflationary impact of more money would then be neutralized, higher inter- est rates would result from having increased government borrowing. Cen- tral bank decisions on intervention in response to capital inflows and then on sterilization of such intervention thus affect the current account, inflation, and interest rates. • How Have the Capital Flows Been Used? It may not matter much that analysts have often ignored capital flows, de- 1983 1984 1985 1986 1987 1989 1990 1991 1992 1993 pending on how such flows have been used. Ideally, in the case of an economy SOURCE: U.S. Department of Commerce, Bureau of Economic Analysis. as dependent on international trade as is Mexico, capital inflows would be largely channeled into investments to boost FIGURE 4 MEXICAN PURCHASES AND SALES productivity and to lower prices on ex- OF LONG-TERM SECURITIES ports, thus improving the BCA, national Billions of dollars economic output, and employment. 25 There is only mixed evidence that this has occurred, however. While the vol- ume of capital goods imports has risen 20 steadily since well before the surge in capital flows, there has been no clear increase in the share of imports ac- counted for by capital goods. The capi- tal flows have also apparently not led to increased domestic expenditures on capital goods, because the share of gross fixed capital formation to GDP has not risen appreciably since before the 1990 surge in capital flows.12 Thus, there is only weak evidence that the capital inflows have been used mainly to invest in productivity enhancement. 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 NOTE: All data are quarterly. The Bank of Mexico has played an SOURCE: U.S. Department of the Treasury, Treasury Bulletin, table CM-V-4. active role in response to capital inflows, as shown in figure 5. The Mexican capi- tal account has trended higher since one could view the imports as being a By intervening to purchase some of the 1990 and has been associated with rec- result of capital flowing into the country. foreign currency flowing into the coun- ord levels of foreign exchange reserves. For example, suppose the international try, the Bank of Mexico prevents the This indicates that the central bank has investment community has become opti- capital inflows from being fully been intervening heavily to prevent capi- mistic about the future profitability of a reflected in the current account and thus tal inflows from being fully reflected in particular Mexican resort and pours reduces spending on imports from the a deterioration in the current account. money into Mexico. Completion of the United States. Another decision con- project would probably require the fronts the central bank once it has inter- importation of equipment and other cap- vened. In buying up the dollars flowing ital goods and thus a movement of the into the country, the Bank of Mexico Mexican capital account toward deficit. increases the money supply (of pesos) FIGURE 5 MEXICO'S CAPITAL ACCOUNT capital inflows have been allowed to AND FOREIGN EXCHANGE RESERVES partially feed through to the BCA, im- plying increased net imports from the Millions of dollars United States, it is not clear that the 25,000 resultant inflows have been used mainly to invest in capital goods that would lead to improved Mexican productivity. The foreign exchange reserves of the Mexi- can central bank are at high levels as a result of intervention in response to the capital inflows. However, it is always possible that higher U.S. interest rates, combined with an increased sensitivity of capital flows to changes in interest rates, would lead to a capital outflow from Mexico. In that case, Mexico's net imports from the United States would -5,000 - drop off through mechanisms seldom explicitly considered in the discussion of -10,000 NAFTA and its aftermath. 1979 1980 1981 1982 1983 1984 1985 1986 1987 1989 1990 1991 1992 1993 NOTE: All data are quarterly. • Footnotes SOURCE: International Monetary Fund, International Financial Statistics. 1. Partially sterilized intervention refers to central bank transactions in foreign curren- cies whose impact is partly felt on the money • How a Capital Outflow Could markets by buying Mexican securities, supply. Alter the Post-NAFTA Economy the money supply would not fall, but the rates on securities would drop, poten- 2. This figure is measured on a customs Despite all of the economic reform value basis (c.v.b.—the value of imports efforts in Mexico, it is still possible that tially exacerbating the outflow and mak- excluding shipping costs) and is equivalent to higher U.S. interest rates, combined with ing it even more inevitable that Mexico's $2.78 billion per year. On a cost, insurance, greater sensitivity of capital flows to net imports from the United States and freight (c.i.f.) basis, the surplus is $164 changes in interest rates, could lead to would decline. million per month, or $1.96 billion per year. capital outflows from Mexico. Without any intervention from the central bank, • Conclusion 3. The ratio of U.S. exports to Mexico as a this would lead to an improvement in Analyses of the post-NAFTA economic percentage of total U.S. exports is calculated Mexico's BCA, which implies fewer net using the International Monetary Fund's scene generally focus on trade, employ- (IMF) Direction of Trade Statistics for imports from the United States and a ment, and output, with little attention 1993:IVQ. U.S. exports as a percentage of negative impact on U.S. employment. In paid to capital flows, which may be U.S. GDP is calculated from the IMF's Inter- this situation, however, the Bank of important influences in the short run. national Financial Statistics (IFS). The prod- Mexico might feel compelled to inter- Because recent capital flows from the uct of the two ratios yields an estimate of the vene to prevent the sale of Mexican United States to Mexico have been ratio between U.S. exports to Mexico and assets from unduly depressing the value larger than would have been expected, U.S. GDP. of the peso. The foreign exchange more attention needs to be focused on reserves would be drawn upon to buy the important roles played by interna- 4. See footnote 3. The sources and method of calculating the ratio between Mexican pesos, leading to a contraction of the tional financial markets and by the exports to the United States and Mexican Mexican money supply, again with neg- Mexican central bank in determining GDP are the same as for calculating the ratio ative impacts on the Mexican economy the size of capital flows and their effects between U.S. exports to Mexico and U.S. and thus on net imports from the United on the Mexican economy, and thus on GDP. Unfortunately, however, the most States. If the Bank of Mexico fully ster- net imports from the United States. recent IFS data that can be used to calculate ilized its intervention in the exchange the ratio between Mexican exports and Mexi- can GDP are for 1992. The short-term impact of capital flows has been somewhat mixed. While the 5. The BCA measures the trade in goods and services, taking into account all unilateral transfers, including private remittances and government transfers. It thus includes all entries other than asset transactions. 6. The U.S. Treasury Department's monthly 9. See Morris Goldstein and Michael Mussa, 12. IFS data show that for Mexico, this data are probably the most frequently avail- "The Integration of World Capital Markets," ratio rose from an average of 0.186 in able for capital flows. These data are filed by International Monetary Fund, paper prepared 1987-89 to only 0.195 in 1990-92. On the commercial banks and other financial institu- for the Conference on "Changing Capital other hand, for Chile, the country to which tions, both U.S. and foreign. These are gross Markets: Implications for Monetary Policy," Mexico's reform effort is most often com- data, referring to the same security possibly sponsored by the Federal Reserve Bank of pared, the ratio rose from 0.210 to 0.233 being involved in more than one transaction Kansas City, August 1993, p. 39. over the same two periods. By way of con- and thus possibly being counted more than trast, the Bank of Mexico reports that the once. These data do not correspond to the net 10. Ibid. ratio of private investment to GDP rose movement of funds implied by the BCA. The from 0.167 to 0.198. See The Mexican main exclusions from the Treasury data are Economy 1994, Mexico City: Banco de 11. See Guillermo A. Calvo, Leonardo Lei- intercompany capital transactions between Mexico, 1994, p. 214. derman, and Carmen M. Reinhart, "Capital the United States and foreign offices of the Inflows and Real Exchange Rate Apprecia- same company and capital transactions of the tion in Latin America," IMF Staff Papers, U.S. government. vol. 40, no. 1 (March 1993), pp. 108-51. In practice, there may be a variety of obstacles, William P. Osterberg is an economist at 7. See, for example, OECD Economic Sur- such as regulations or taxes, that prevent the Federal Reserve Bank of Cleveland. veys: Mexico 1991/1992, Paris: Organisation investors from moving funds to take advan- The author thanks Rebecca Wetmore for Economic Co-operation and Develop- tage of differences in interest rates. Humes for excellent research assistance. ment, 1992, pp. 26-36. The views stated herein are those of the author and not necessarily those of the 8. Although most studies of NAFTA do not Federal Reserve Bank of Cleveland or of predict capital flows, they implicitly assume the Board of Governors of the Federal that capital flows are sufficient for savings to Reserve System. equal investment. See box on page 2. Federal Reserve Bank of Cleveland BULK RATE Research Department U.S. Postage Paid P.O. Box 6387 Cleveland, OH Cleveland, OH 44101 Permit No. 385 Address Correction Requested: Please send corrected mailing label to the above address. 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