Academic journal article Multinational Business Review

What Have We Learned from the "Tequila Effect" and Asian Currency Crisis?

Academic journal article Multinational Business Review

What Have We Learned from the "Tequila Effect" and Asian Currency Crisis?

Article excerpt

This paper compares the recent Asian currency crisis with the Mexican financial turmoil a few years earlier. It examines the benefits and risks associated with financial liberalization in emerging markets and proposes several solutions that are aimed at minimizing such risks. The author concludes that having a sustainable macroeconomic policy framework and a healthy financial system in place is an important precondition for liberalizing capital accounts. Fully opening a capital account without the support of sound polices and the strength of financial systems and institutions may prove to be extremely disruptive to economic growth.

INTRODUCTION

The world financial markets are becoming an increasingly integrated global marketplace, and emerging economies are being pulled into this rapid pace of financial innovation and globalization at varying speeds. Some of them have built up the necessary institutions and architecture, adopted sound economic and exchange rate policies, and consequently been able to reap the benefits of their newly acquired access to global financial markets. The others, unfortunately, seemed to be ill prepared for the risks associated with rapid liberalization of their financial markets. They find themselves more vulnerable to herd behavior and start to doubt whether the financial integration will do them more harm than good. Furthermore, the choice whether to be integrated or not does not rest solely with them any more. The big strides the world has made in telecommunications and information technology have made it increasingly impossible for any nation to insulate itself from the rest of world. It is, therefore, quite timely to revisit the policy issues that center on reducing the volatility of capital flows and the vulnerability of emerging markets in this increasingly dynamic and interrelated financial systems.

As you may recall, the 1980s reputations as a period of increasing globalization and deregulation in financial markets. Overall, restrictions have been gradually relaxed with an acceleration of this process occurring in the 1990s. These developments have brought substantial capital flows to emerging equity markets. There has been ample evidence of shifts in capital flows between emerging and mature markets in the recent years. The Asian financial crisis, and the Mexican crisis and its immediate aftermath a few years earlier --the so-called the "Tequila Effect", remind us of the benefits and concurrent risks associated with liberalization of capital accounts. These crises surprised the world by demonstrating the perilous vulnerability in their financial and exchange rate systems.

MEXICO'S FINANCIAL CRISIS

Between the late 1980s and 1993, Mexico underwent a period of rapid economic transformation. These reforms included privatizing many state-owned enterprises, removing restrictions on foreign investment, and reducing inflation and government spending, which were accompanied by continued efforts at seeking economic prosperity through trade liberalization. In January 1994, Mexico joined Canada and the United States in the North American Free Trade Agreement (NAFTA). This membership opened Mexico to more foreign investment and bolstered foreign investor confidence in the country. Capital flows to Mexico changed from a cumulative net outflow of about $15 billion during 1983-89 to a cumulative net inflow of $102 billion during 1990-94, representing roughly one fifth of all net inflows to developing countries.

However, a combination of adverse political and external shocks a large current account deficit, and inconsistency between Mexico's monetary and fiscal polices and its exchange rate system in 1994, led to an increasing loss of investor confidence and a collapse of the peso. On the external front, the increase of the U.S. federal fund rates of 25 basis points to 3.25 percent on February 4, 1994, was followed by a series of additional interest rate hikes in the U. …

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