The Giant Sucking Sound: Did NAFTA Devour the Mexican Peso?

By Neely, Christopher J. | Federal Reserve Bank of St. Louis Review, July-August 1996 | Go to article overview

The Giant Sucking Sound: Did NAFTA Devour the Mexican Peso?


Neely, Christopher J., Federal Reserve Bank of St. Louis Review


At the end of 1993 Mexico was touted as a model for developing countries. Five years of prudent fiscal and monetary policy had dramatically lowered its budget deficit and inflation rate and the government had privatized many enterprises that were formerly state-owned. To culminate this progress, Mexico was preparing to enter into the North American Free Trade Agreement (NAFTA) with Canada and the United States. But less than a year later, in December 1994, investors sold their peso assets, the value of the Mexican peso plunged 50 percent against the U.S. Dollar, and Mexico was forced to borrow from the International Monetary Fund (IMF) and the United States to get through a financial crisis. In 1995, inflation in Mexico soared to 50 percent and real gross domestic product (GDP) fell by 4 percent.

Politicians and commentators like Ross Perot, Pat Buchanan, William Greider, and Robert Kuttner blamed the enactment of NAFTA for the devaluation of the peso and the ensuing economic turmoil in Mexico, with some calling for its renegotiation or even repeal. As the members of NAFTA consider expanding to encompass other Latin American nations, such as Chile, investors and policymakers should understand the link between NAFTA and the peso crisis well. Did NAFTA cause or exacerbate the devaluation of the peso? Or did NAFTA help alleviate some of the consequences of the crisis?

This article examines the relationship between NAFTA and the peso crisis of December 1994. First, the provisions of NAFTA are reviewed, and then the links between NAFTA and the peso crisis are examined. Despite a blizzard of innuendo and intimation that there was an obvious link between the passage of NAFTA and the peso devaluation, NAFTA's critics have not been clear as to what the link actually was. Examination of their arguments and economic theory suggests two possibilities: that NAFTA caused the Mexican authorities to manipulate and prop up the value of the peso for political reasons or that NAFTA's implementation caused capital flows that brought the peso down. Each hypothesis is investigated in turn.

NAFTA

NAFTA grew out of the U.S.-Canadian Free Trade Agreement of 1988.(1) It was signed by Mexico, Canada, and the United States on December 17, 1992. The legislatures of those countries ratified NAFTA, and the agreement took effect on January 1, 1994. The treaty substantially lowered national barriers to trade and investment in North America, giving consumers more choices and lower prices. In addition, the changes began to lower the cost of production and to funnel investment and labor to their most productive uses. Not surprisingly, the costs - real and imagined - of this reallocation of resources stirred the passions of those opposing the agreement.

The trade provisions of NAFTA were designed to reduce tariffs and nontariff barriers - such as quotas and import licensing - radically over 15 years. Some tariffs were reduced immediately, whereas other reductions will be phased in over a period of 10 years - 15 years for certain sensitive sectors, such as agriculture and textiles and apparel.

For the United States and Mexico, the trade provisions of NAFTA are expected to have their most important effects on the automobile, textile and apparel, and agricultural sectors. In agriculture, U.S. and Mexican quotas were immediately converted into equivalent tariffs and those tariffs will be phased out over 10 to 15 years. As Hufbauer and Schott (1993) note, this is a remarkable achievement given the difficulties encountered by other free trade agreements on agricultural issues.

Given the fierce fight in the United States over the agreement, it is ironic that NAFTA required more substantial changes in Mexican law - both trade and investment law - than it did in U.S. law. Average U.S. tariff levels on Mexican goods were already quite low - just four percent - on a value-weighted basis, before the introduction of NAFTA. …

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