The Effects of External Capital Flows on Developing Countries: Financial Instability or

"Wrong" Prices?
Author(s): Noemi Levy Orlik
Source: International Journal of Political Economy, Vol. 37, No. 4, Financial Flows and
Exchange Rate Movement in the Global Economy (Winter, 2008/2009), pp. 80-102
Published by: M.E. Sharpe, Inc.
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International
JournalofPoliticalEconomy,
vol. 37, no.4, Winter
2008-9,pp. 80-102.
© 2009M.E. Sharpe,
Inc.Allrightsreserved.
ISSN 0891-1916/2009$9.50+ 0.00.
DOI 10.2753/IJP0891-19
16370404

NoemiLevy Orlik

The EffectsofExternalCapital Flows

on DevelopingCountries
FinancialInstability
or"Wrong"Prices?

Abstract:This paperdiscussestheeffectsof capitalmovement on developing

economieswhoseproduction structuresarehighlydependent on foreign technol-
ogyandimports. Itis arguedthat,insteadofincreasing
savingsandinvestment and
maximizing economicgrowth, external capitalflowsinducefinancial instability,
whichmodify "key"pricesanddepresseconomicactivity. Thisanalysisis based
on theassumption thatmoneyis endogenous andtherateofinterestis exogenous;
theexchangerateinducesinflation witha magnifiedpass-througheffect to con-
sumers,and therateof interest is a distributional
variablewhosemainobjective
is torestorefinancialgains.

Keywords:Capitalmovements, economies,
developing money(Post
endogenous
Keynesiantheory),
prices.

Formainstream theprincipal
economists, arguments explaining thebackwardness
ofdeveloping countries
havetodo withtheshallowness andnarrowness offinancial
marketsandthelackofan international
currency tofinance economicdevelopment.
Moreover, theslow economicgrowth is said to resultfromreducedsavingsas a
resultof financial
marketsegmentation and limitedexternal capitalmobility,as
wellas from"wrong"prices,becauseofgovernment intervention.
Accordingly, twopoliciesareusuallyputforth. First,thefinancial
system needs
tobe widenedanddeepenedbyincreasing thedemandforandsupplyoffinancial
instruments;inotherwords,a greater
number offirms mustissuefinancial instru-
mentsthat,inturn,moreagentsneedtodemand.Second,moneymarkets needtobe

NoemiLevyOrlikisa professor
ofeconomics,
Universidad
Nacional
AutónomadeMéxico,
Mexico;e-mail:levy@servidor.unam.mx.
Theauthor
thanksL.R Rochonas wellas an
anonymous forhelpful
referee, comments.

80

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 WINTER2008-9 81

openedtointernational markets (financialglobalization)toincreasetotalsavings,1

whichifcomplemented withfreetrade,ensures"correct"pricesand maximum
efficiency.Undertheseconditionsdomesticand international "real" pricesare
supposedto equalizeso thatexternal capitalmarket equilibrium can be attained
through exchangeratemovements.
Post-Keynesians rejecttheseviews.On theone hand,J.M.Keynes's(1936)
and H. Minsky's(1987) analyses,based on theliquiditypreference theoryand
thefinancial instability
hypothesis, respectively,emphasizetheviewthatcapital
movements aredestabilizing andgenerate economiccycles.Forhorizontalists, such
as NicholasKaldorandBasil J.Moore,moneyis fullyendogenous andtherateof
is determined
interest exogenously bythecentral bank:themoneysupplyisdepicted
as a horizontalschedule- infinitelyelasticininterest-rate/money space.Circuitists
(see,amongothers, JacquesLe Bourva,MarcLavoie,andLouis-Philippe Rochon)
taketheanalysisa stepfurther byarguing thattherateofinterest is anadministered
priceandnotdetermined bymarket variable.Forthe
forces;itis a distributional
financial
latter, flowsnotrelatedtoproductive creditdestroy existing debtor,more
precisely, financialflowsunrelated to spendingon consumption and investment
destroydebt.Consequently, market
financial depthresulting,say,from globalization
can neither expandeconomicactivity norinducefinancial instability.
Whiletheseconditions applychiefly toindustrial economies,theynonetheless
arerelevant to developing economies,providedthefollowing twoconditions ap-
ply.First,thedepthoffinancial markets is nottheresultofbroadfinancial activity
(thesellingandbuyingofprivate financial instruments),butrather is causedbythe
issueof publicfinancial instruments, themainfunction of whichis to guarantee
financialmargins. Second,financial flowsdistort themainpricesoftheeconomy,
inparticular, theexchangerateandwages,whichthenmodify indirectly economic
As such,external
activity. capitalcannotautomatically expandproduction orpro-
ductivecapacity, because,in mostcases,itmerelydestroys debt.

Effluxand RefluxMechanisms

Thedemandforcreditis thestarting pointofmoneycreation andproduction.Busi-

nessesrequirecreditformeeting production costs(e.g.,wagesandoperatingcosts)
andexpansion(e.g.,thefinancing ofinvestment) - whatRochon(2005) hascalled
short-termandlong-term Thesecreditsareissuedbycommercial
credits. banksas
longas borrowers complywithcreditworthiness rulesthatmaychangeovertime.
Creditsare issuedthrough linesof creditor bankdeposits,whichare meansof
payments thathavetheabilityto settledebtsand perform of
nearlyall functions
centralbank(or base) money.
FollowingKeynes(1937), creditsare createdthrough simplebalancesheet
operationsregardless of previousresources(ex nihilo),implying therefore
that
realresources areneitherdepletednorabsorbedinthecreditcreationprocessnor
limitedbysavings.2Also,forhorizontalists, themoneysupplyis notindependent

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82 INTERNATIONAL JOURNAL OF POLITICAL ECONOMY

ofinterest-rate movements, andcreditrationing is basedonnonprice mechanisms,

suchas normsofcreditworthiness (see Rochon2001).
For proponents of themonetary circuit,thisprocessinvolvestwo financial
flows(see RochonandRossi2004). First,private money, whichis createdthrough
creditsand deposits-andwhichenablesus to makepayments beforerevenues
arecreated(see Gnos2006)- increasesbothincomeandthemoneysupply.This
processis knownas theefflux mechanism: itis thecreation orinjection ofmoney
intotheproductive sphere.However,onceincomeis consumedorsaved(unspent
incomecreates"savings"or deposits,see Gnos 2006),3incomeis returned to
firms. Consumption and thepurchaseof financial assetsin thissenseare similar
acts,becausein bothcases, incomeis returned to firms. At thisstage,firmsuse
thisincometo retiretheirdebtwiththebankingsystem. Debtsarecanceledand
moneyis destroyed. Thisprocessis knownas thereflux mechanism. Ofcourse,if
households andwageearners hoardsavings,thenfirms do notsucceedincapturing
all oftheirinitialoutlays.
An interestingconclusiondrawnfromthisanalysisis thatmoneyandpricesare
unrelated.Consequently, a higherlevelofeconomicgrowth requireshigherlevels
of moneysupply,withno effecton prices,becausethemoneysupplyis related
to higherproduction or expandedproductive capacity, therebybreaking thelink
betweenmoneysupplyandprices.Inflation is largelycost-push andtheresultof
conflictoverthedistribution ofincome.
Thesecondflow(central bankmoney)results from commercial banks'interbank
deficit.Commercial banksuse centralbankmoneytosettleinterbank debtson the
booksofthecentralbank,guaranteeing thateachcommercial bankis able tobal-
ance itsbooks,evenunderconditions of unequaldistribution of depositsduring
theprocessof moneycreation(RochonandRossi 2004). It has beenarguedthat
thisconstitutes an alternativeviewtoChartalism.4
Indeed,as earlyas thelate1950s,Le Bourva(1992) arguedthatthemoneysupply
is a dependent variable.Centralbankstherefore cannotmodify theamount ofliquid-
itythrough changesin themonetary base. Rather, a centralbankaccommodates
all commercial banks'demandforreserves. As such,thebenchmark interest rate
is themainmonetary policyinstrument, determined bythemonetary authorities,
thereby reversing thecausalityputforward byproponents ofthequantity theory of
money(Lavoie 1992).The relevant causalitygoes fromthedemandforcredit,to
thesupplyofcreditandthecreation ofmoney(moneysupply),higher income,and
finallytothedemandforandsubsequent supplyofcentralbankmoney(reserves).
As a result,themoneymultiplier is a fallacy.5
Fromtheabovearguments, horizontal istsandcircuitists highlight twoimpor-
tantissues.First,thecentralbankis forcedto satisfy (accommodate) all reserves
demandedbycommercial banksto avoidfinancial - hencethecentral
instability
banks'continuous surveillanceofthebanking system inordertomitigate financial
disturbances. Notonlyis ita lenderoflastresort, butitmustalso intervene daily.
As Rochon(1999) indicates, thiswas alreadyexplainedinA. Eichner(1987),who

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 WINTER2008-9 83

calledthisthedefensive roleofthecentral bank.Second,higher liquidityis related

tohigher productionorinvestment spending. Consequently changesinproduction
or investment spendingneednotinducefinancialinstability normodifyprices,
especiallyinterestrates.
The relevant issueis thatbankcreditprecedesmoney.6 Also, therefluxto the
financial systembymeansofgoodsandservicespayments - orthrough financial
market securities
holdings- cancelsoutdebts.Indeed,all shortages ofcommercial
bankreservesareaccommodated bythecentralbank;as such,financial instabil-
ity is not theresultof notdestroying existing debts.Moreover, if liquidityrises
independently ofcreditdemand, this excess supplyof money is used toextinguish
debt.As Lavoiestates:"whenagentsdisposeofmoneybalances,thattheywishnot
to hold,theseexcessmoneybalancescan be extinguished bythereimbursement
ofpreviously accumulated debt"(2001,215).
The funding process(whichdealswithtemporal asymmetries betweeninvest-
mentdebtsandcash flowreturns) is no longera centralelementin thefinancial
system, becausecapitalmarkets are less linkedto investment finance.It nowis
accepted thatstockissuance is connected to (mergers
speculation andacquisitions)
rather thanto meettheneedsforprivateinvestment finance.

Effluxand RefluxMechanismin DevelopingEconomies

Giventheforegoing, in thissectionwe analyzethecreationand destruction of

money as it to
applies developing economies. The latter are characterized by
economicandfinancial dependencewithina contextofhighcapitalmobility and
economicglobalization (productiveand where
financial),7 internalproduction,even
fordomesticmarkets, dependson external markets.
Economicopennessthatcharacterizes developingcountriesdoes notdimin-
ishtheefflux andreflux mechanisms. Indeed,providedexternal capitalflowsare
relatedtoproduction orinvestment spending, thecentralbankissuesmoremoney
andcommercial bankdepositsincrease, leadingtohigher incomeandconsumption
levels.As a result,debtsarereimbursed (including external debts)andcentral bank
money settles domestic interbankdebts (Le Bourva 1992, 462).
The endogenousmoneytheorycontinuesto applyprovidedexternalcapital
inflowsare relatedto productionor investment spending,because debtsare
canceled.Indeed,whilenotesandcoins(centralbankliabilities)couldincrease,
liquiditywithin thebankingsystem doesnotincreasebecausesterilization occurs
automatically. In otherwords, centralbanks willtend to neutralizethese external
debts- thisis thecompensation principle,whichis madeclearbyLavoie:"because
themovements of someelementsofthecentralbankbalancesheetareautomati-
callycompensated byoppositemovements in otherelements"(2001, 216).
To date,we havenotdiscussedtheexchangerate,whichplaysa keyrolein
open(orglobalized)developing economies. According tothemainstream approach,
exchange rates should guaranteeequal real prices across economies (e.g., the

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84 INTERNATIONAL JOURNAL OF POLITICAL ECONOMY

principle ofpurchasing powerparity[PPP],inabsoluteand,especially, inrelative

terms),which,ofcourse,is rarely, ifat all,observablein therealworld(e.g.,the
Big Mac or Starbucks indexes).A possibleexplanation is thelackof substitution
betweenimported anddomesticgoodsand services:market segmentation in the
productive sector,productdifferentiation, lengthy processesofpriceadjustment,
different productivity levelsbetweentradableand nontradable goods(especially
indeveloping countries, see Krugman andObstfeld1999,chapter14),areall pos-
siblecauses of thecollapseof PPP. M. Lavoie (2001, 219) preciselyarguesthat
althoughPPP mayholdin themediumand longrun,in theshortrunexchange
ratedevaluationscould inducehighercosts- and therefore higherprices - for
foreign goodswithout modifying effective demand,becauseinflation is followed
bysalaryincreases.
In addition,accordingto theinterest-rate parityprinciple(IPP), interest rates
acrosscountries areequalized,providedthatmarkets achieve"correct" (i.e.,equi-
librium) exchangerates.Therefore, IPP is explainedinterms ofmoneysupplyand
inflationdifferentials amongcountries. Hence,expectedexchangeratemovements
tendtoequalizeinterest rates.Again,empirical evidencecontradicts thisexplana-
tion,especiallyin developingeconomies.One reasonis thatdomesticfinancial
assetsare notperfectsubstitutes forforeignfinancialassets,and exchangerate
movements areexplainedinterms ofcapitalinflows andoutflows (seekingfinancial
gains)rather thanpricechanges.
Anotherpossibleexplanation, based on M. Kalecki'stheoryof pricedeter-
mination (see Kalecki1954a),is thepass-through effect.Accordingto thisview,
exchangeratedepreciation mainlyaffects production (domesticorforeign) based
on foreigninputs:theyincreaseinputcosts,butifthereis competition between
producers basedon domesticandforeign inputs, thelatterwillreducetheirprofit
margin so as nottoincreasepricesandthereby remaininthemarket; alternatively,
wagescan be reducedtoneutralize higherimport costs.To wit,theproblem is the
dependenceon foreigninputs.If all producers (domesticor foreign)use foreign
inputs,depreciation affects all producers alike.However,ifthereis competition
betweenthosewhousedomesticandforeign inputs,onlythelatter willbe affected,
andtheywillreducetheirprofit margin.
Regardingthefirstargument, if competition prevails,theincreasedcostsof
imports arenotfullypassedon to prices.8 According to Lavoie,"thereis a lotof
empiricalevidenceaboutthelackof a pass-through effect, whenthereis a rela-
tiveappreciation of theirowncurrency, foreignproducers lowertheirmark-ups
and absorblosses to makesurethatthepricesare in linewithlocal producers"
(2001, 219). The underlying assumption is thatgoodsand servicesareproduced
by domesticand foreignproducers thatcompetewitheach other,andexchange
ratedepreciation affects mainlyforeign producers becauseoftheirhigherimport
coefficient.Consequently, toremaininthemarket, profitsharesarereduced.More-
over,domestic producers areunaffected byexchangeratemovements becausetheir
import coefficient is low.

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 WINTER2008-9 85

thisargument
However, doesnotholdintheMexicaneconomy, becauseforeign
anddomestic producers haveroughly thesameimport (especiallyinthe
coefficients
dynamic sector).In thiscase,thereis nocompetition amongthemandhigher costs
arefullypassedontoprices;henceexchangeratedepreciation affectsall firms.
This
is oneexplanationofthefullpass-through effect.
afteran exchangeratedevaluation,
Moreover, wagestypically decrease(rather
thanincrease)eventhoughinflation setsin; wage reductionscan prevent prices
fromgoingup,thereby leavingunchanged margins.
profit TheEconomicCommis-
sionforLatinAmericaandtheCaribbean(ECLAC) hasarguedthat,indeveloping
wagesaredetermined
countries, bytheprevailing livingconditions oftheregion
(lowerthanindevelopedcountries) andareunrelated toproductivitychanges(see
citedinLevy2007).As such,wageswilldecrease,orincreaselessthan
C. Furtado,
prices,whentheexchangeratedepreciates.

The EffectsofExternalCapital Flowson Liquidityand Pricesin

theMexicanEconomy

To testthehypothesis outlinedabove,thissectionis dividedintothreeparts.First,

we analyzetheeffects ofexternalcapitalflowson liquidity andwe arguethatthe
monetary base remains unchanged since externalcapital inflows are relatively
unconnected to investment spending. Second, we demonstrate that theMexican
production structure has changedas a of
result globalization andFDIs, leadingto
a directcorrelation betweenexchangeratedepreciations (appreciations)andeco-
nomicstagnation (growth).Finally,we consider the relationshipbetween capital
movements andprices,particularly theeffectofexchangerateson prices,wages
andinterest rates.

Mechanism
and theCompensation
ExternalCapitalMovements

An important characteristicof LatinAmericaneconomiesis thatcapitalinflows

dramaticallyincreased in thelate 1980s,9and moreimportant, theywerehighly
disconnectedfromproduction andinvestment spending.Before the 1994Mexican
crisis,foreignportfolioinvestments (FPI) dominated externalinflowsand were
directedtoward Mexicangovernment bonds(theinfamous Tesobonos).As a result
ofNAFTAandthe1994crisis,foreign directinvestment (FDI) displacedFPI and
continued tobe unrelatedto investment spending, largelybecausetheywereused
to acquireexistingcapital(mergers - a majorcharacteristic
and acquisitions) of
globalizedtrade(see Dumenil and Levy 2005). Consequently, theneoliberalargu-
mentsforopeningup thefinancial systemdidnotoperateas promised.10
One elementthatreflects thedisconnection betweenexternalcapitalinflows
andproduction and investment spending is therelative
stabilityof themonetary
basethroughout thisperiod.Indeed,as canbe seeninFigure1, thereareincreased
levelsofinternationalreservesalongsideexternal capitalinflowsandreducednet

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86 INTERNATIONAL
JOURNALOF POLITICAL ECONOMY

12 -

ιο-
ί" "ι
β · · *' *---
II ·

^- ^--' „ί* -
ν
-^ " - -^

Ί Λ ί /ϊ ? ι'ϋν '/îV ί * ί ί- ? ' ' ' ' '

α Α i li i i six/ i i i > s^^J i i i i 's*'^

-β

Ι ^- ·ΜΒΛ5ΟΡ - - IFVGOP I4KVGÕP I

I Un- f(MBAGOP) Un- f(MB^iOP) |

Figure1. MonetaryBase Composition in Terms of InternationalReserves

and Net InternalCredits
Source:Bancode Mexico,www.banxico.org/mx.
base; IR: international
MB: monetary reserves;NIC: Netinternal
credits

internalcredits(see Table 1). Actuallyafterthe 1994 crisis,international reserves

anchoredthe exchange rate,and net internalcreditscontinuedto be the accom-
modativevariable thatoffsetexternalflowsunconnectedto productiveactivities
(i.e., in accordance withthecompensationprinciple).
As fortherelationship betweeninternational reservesand thesterilization
mecha-
nism,itis interesting to noticetheincreasedportionof international reservesin the
centralbank's balance sheet,accountingfor72 percentof centralbank assets in
2005 (see Table 2). Also, centralbank claims on thegovernmentdisappeared,and
its claims on banks decreased significantly, withtheexceptionof the 1995-2000
period,mainlybecause of theMexican government'srescueof financialinstitutions
(particularlythebankingsector).Actually,in 2000, centralbankcreditto commer-
cial banks averaged 15 percentof centralbank totalassets (see Table 2).
The centralbank's liabilityside shows thereductionof netinternalcredits.First,
bankdepositsat thecentralbank increased,reachingin 2005 close to 30 percentof
totalcentralbank liabilities- a level not seen since the 1980s when legal reserve
requirementswere in operation.(For further discussion,see Levy and Toporowski
2007.) Second, the centralbank benefitedfromfiscal supportas governmentnet
depositsin thecentralbankreachednearly20 percentof totalliabilitiesin 2000. As
a result,thefiscaldeficit(netcentralbank claims on thegovernment)was replaced
by netgovernmentsupportto centralbanks.

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 WINTER2008-9 87

Table 1

Mean and Standard Deviation of the MonetaryBase and Its Components

International
base
Monetary reserves Netinternal
credits

1985-2005
Mean 3.8 5.8 -2.0
SD 0.2 2.3 2.5
1985-1989
Mean 4.3 5.2 -0.9
SD 0.6 3.1 3.1
1990-1995
Mean 3.6 4.5 -1.0
SD 0.2 1.4 1.5
1996-2005
Mean 3.7 6.9 -3.2
SD 0.5 1.4 1.0

Source:Bancode Mexico,www.banxico.org/mx.
deviation
SD: Standard

(ExportSector)oftheMexican
Structure
TheNewProductive
Economy

ofexternal
To analyzetheeffects capitalinflows todeter-
on prices,itis necessary
how
mine,first, dependent (or independent)thedomestic manufacturing sectoris
on external
markets,especiallyexport-orientedsectors(the dynamic ofthe
sector
economy).Only then can we betterunderstandwhether exchange ratemovements
modify economicactivity.

oftheExportSector
TheComposition

In thelastfewdecades,theratioofexportsto GDP increasedquitedramatically,

especiallyafterNAFTA(see Table3,col. 3).' ' Whatis particular
abouttheMexican
economy is thattheexport-orientedhigh-tech manufacturingsector most
increased
15
(approximately percent), easilydisplacing themining which
sector, decreased
by about20 percent, and thelow-techmanufacturing sector,whichdeclinedby
5
approximatelypercent; there were no important changes to theagricultural,
and
forestry, livestocksectors(see Table3).

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88

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 WINTER2008-9 89

The increasedshareof high-tech manufactured goods in totalexportscoin-

cidedwithhighlevelsofimported goods, which remained relatively
unchanged,
especiallywithrespecttoexchangeratemovements resultingfromtechnological
dependenceon foreign capitalgoodsand inputsthatmadeimportdemandprice
inelastic.
As a resultofthemanufacturing activitythatdiversified Mexicanexternal trade,
Mexicofacedlargecurrent accountdéficits becauseofitshighdependence on ex-
ternal(rather thandomestic)markets (see Table3, lastcol.). Exportsremained dis-
connected fromlocaldomesticproduction, as intheprimary sectormodel,thereby
creating export-oriented manufacturing enclaves,reminiscent ofthepreindustrial-
izationeraofthebeginning ofthetwentieth century, although nowmanufacturers
withhightechnology coexistwiththosethatprimarily use rawmaterials.
Developingcountries remained technologically dependent andunabletocom-
pete with industrialized as rate
countries; such,exchange stability continued tobe
distorted, because they need to be stable to
(overvalued) keepprices under control.
Exchangeratestability keptpricesundercontrol, yetitstillcouldnotbalancethe
externalcurrent account.Intheperiodfollowing MexicojoiningtheGATTin 1985,
thepriceinelasticity ofdemandforbothexportsandimports strengthenedandthe
incomeelasticity ofdemandincreased(see Moreno-Brid 2002).
Consequently, exchangeratedevaluations did notaffectthecomposition of
imports, as should be the case under PPP, neither in absolute and terms.
relative
Rather,it onlymodifiedits volume;thecomposition of exportsalso remained
unchanged, on
depending foreign countries' income.
Itshouldbe emphasized thatFDI continued toinfluence mostofmanufacturing
even its
activity, though production was reoriented tomeet the demandofexternal
markets. the
(During import-substitution industrializationperiod,itsatisfied
internal
demand.) More the of the
important, productivity manufacturing sectorincreased,
becauseitscapitalequipment wasnolongerbasedonobsoleteorsecond-generation
technology. Thus, there was no integration betweenthedomesticproduction sector
and industries specialized in advanced This
technology. onlyamplified internal
segmentation.

and ExchangeRateMovements
EconomicGrowth

Undertheconditionsdescribedabove,insteadof inducingeconomicgrowth, ex-

changerate tend
devaluations tohalteconomic Hence,
activity. developingecono-
miescontinuedtorequire exchangeratestotrigger
distorted economicgrowth. The
1976exchangeratedevaluation, forinstance,
(thefirst
one aftertwenty-five
years
flattened
ofexchangeratestability) economicgrowth. Nonetheless,theeconomy
recoveredrather ex-
quickly,givenhigheroil prices,whichled to an overvalued
changerateand induced one of thelasteconomic booms of the regulated of
era
theMexicaneconomy(1977-81) (see Figure2). Similarly, the 1982 exchange
was followedbya periodofeconomicstagnation,
ratedevaluation accompanied

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90

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 91

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 JOURNALOF POLITICAL ECONOMY
92 INTERNATIONAL

Figure2. The Relationship Between Exchange Rates and Economic Growth

GDP: Grossdomestic Under/over:
product; undervaluation oftheMexican
orovervaluation
exchangerate
250 ι

200 t

50 Í 'J7 l' /R

- -ER Devaluation Inflation

Figure3. Exchange Rate Movement and Inflation

by undervaluedexchange rates and high inflation.Undervalued exchange rates

induced lower domestic demand, and manufacturedgoods were channeled to
externalmarkets(exports),constitutinga displacementfrominternalto external
demand.At thebeginningof the 1990s, theMexican financialsystemwas liberal-
ized and contributedto an overvaluedexchange rate.As a result,economic growth
resumed(althoughat smallergrowthratesin comparisonto the 1978-81 period).

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 WINTER2008-9 93

Figure4a. Exchange Rate and Producer Price Index (annual growthrates)

priceindex;ERI:Exchange
PPI:producer rateindex
Thetwoindexarebasedonannual rate(onemonth
growth thesamemonth
against inthe
previous basedonDecember
year), 2004andaremoving offivemonths.
average

However, the1994exchangeratedevaluation abruptlystoppedeconomicgrowth.

Whatfollowedwas one of theworstperiodsof economicstagnation in modern
timesforMexico.Considerthat,in 1995,GDP growth was actuallyminus6 per-
cent.Shortly after,as a resultofmassiveFDI inflows, theexchangeratewas once
again overvalued: economic growth quickly ensued,resultingfromlargeincreases
inexports (until2000), which was followedbyhigher pricesandlargermigrant
oil
remittances (2000-2006) (see Bleckerand Seccareccia 2007).
Fromthisdiscussion, we can see thatthereappearstobe a correlationbetween
capitalout(in)inflows and an under(over)valuedexchange rate.Capitalmovements
arethenexplainedbyoneofthefollowing American
hypotheses: economicgrowth
(thisrelationhas become weaker because of thesurgein Chineseimports), higher
exportprices(especiallyoil), U.S. interest ratemovements, whichinducelarge
FPI movements in and out of developingeconomies,foreigndirectinvestment,
andremittances. Also,thereis a correlationbetweenover(under)valued exchange
rateandeconomicgrowth(stagnation).

TheImpactofExchangeRateson Prices

theeffect
Economicopennessincreased ofexchange because
rateoncostsandprices,
external movements
capital remainan determinant
important ofexchange The
rates.

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94 INTERNATIONAL
JOURNALOF POLITICAL ECONOMY

CPI-PPI
1.8 j 0.25

gSSSSSSSSoooooooooooSoooo

Figure4b. Consumer and Producer Price Movements (annual growthrate)

CPI: consumerpriceindex;PPI: Producer
priceindex
The twoindexarebasedon anualgrowthrate(one monthagainstthesamemonthin the
previousyear),basedon December2004 andaremovingaverageoffivemonths.

Mexican centralbankadoptedthepolicyof stabilizingtheexchangerateas an inter-

mediatetargetto controlinflation.In thissection,we shall analyze theeffectof the
exchangerateon pricesand shallarguethatexchangeratedevaluationsinducehigher
costs (inputs)thatare completelypassed on to consumerprices;alternatively, these
costs can be neutralizedwithlower wages. Interestratesare set to guaranteehigh
financialcapitalreturns(externaland domestic)or to modifyincomedistribution.

The Effectsof Exchange Rates on Prices

Between 1980 and 2005, exchange rate movementswere highlycorrelatedwith

pricemovements.Whenevertheexchange ratedepreciated,inflationwould go up.
Similarly,withexchangerateovervaluations,inflation decreased(see Figure3). The
reasonis quitesimple.Withdevaluationthecostof importsincreasesand,sincethere
is no competitionbetweenforeignand domesticproducers(or substitution between
imports and domestic producedgoods), thesecosts are fullypassed on to prices.
There are two othercorrelationsthatare quite relevantto this analysis. First,
consider the effectof exchange rate movementson producerprices. If competi-
tionexists,we expect foreignproducersnot to pass the fullcosts (of imports)to
producerprices. However,the movementsof these two variables in the Mexican
economy show a different direction.In Figure 4, we can see thatexchange rate
movementsinduce higherproducer prices, reflectingweak competitionin the
Mexican economy.Hence freertrade(as a resultof thenumeroustradeagreements

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 WINTER2008-9 95

00' Ç2rr/*^^' ^ Φ Ο CNJ CO l/j 1^ 00 Ο CM CO LO

■ι
1
O) ' oar oo χοο φ ο) ο ο οχ σ> o o o o o
τ- ' φ) CJ> oD p)0>CJ)OíCJ)OíCJ)0000

"2
ALCI CPI CPI-ALCI

Figure5. Consumer Prices and Average Labor Cost Movements (annual

growthrates)
ALCI: Average labor cost index. CPI: Consumer price index
The two index are based on annual growthrate (one monthagainst the same monthin the
previousyear), based on December 2004 and are five-monthmovingaverage

CO qé ι- ICOΓ^- ^'σ> y^rOF^^TvLO Qr~^/o) ι- CD i- "3"

^j €> O JO,t- c5 V^O Ο *ί ι</^ 5 $ $ 5 ^ 5
Λ_ á η m toi ν fe ο w co ^Ίλ (σ ν ο ο
£0 00~ GO to Ο) Ο) Ο) ΛΛ (7)0)0)00000
w co^t cd
-Ό.Ό ^S &jß
τ-f ^) ÇT'Jp Ο) Π) Ο) Ο) Ο) θΤ'ρ> Ο) Ο) Ο Ο Ο Ο Ο

-1-5 'Ι . . -PPI-ERI

- -CIP-PPI
_2

Figure6. The Three Pass-Through Effects

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 JOURNALOF POUTICAL ECONOMY
96 INTERNATIONAL

250-

0«3£$3S£!SS8§3
! * * ? ? ? 5 S? ? S m <3 *

-50

| ER devaluation■ ■ Interest
rates |

Figure7. Exchange Rate and InterestRate Movement

signed by Mexico), highercapital movements(FPI and even FDI) has increased

concentrationand discouragedcompetition.
The secondrelevantcorrelationtakesplace betweenmovementsofconsumerand
producerprice indexes (CPI, PPI, respectively).Again, a fullpass-througheffect
can be observed(see Figure4a). The differencebetweenCPI and PPI, on average,
is greaterthanzero, meaningthat,on average,consumerprices increasein excess
of producerprices.Nonetheless,from2003, theproducerprice index exceeds the
consumerprice index (CPI), whichcan be attributed to less inflationary
pressures
fromlower wages, as discussed in the nextsection.

Income
Exchange Rate, Prices and Workers*

The most strikingfeatureof the Mexican economy is the relationshipbetween

averagelaborcosts (ALC) and theconsumerpriceindex(CPI), whichconfirmsthe
full(or magnified)pass-througheffect.For instance,between 1982 and 2006, the
difference betweenthesetwo variableswas negative(see Figure5), implyingthat,
on average,laborcostsincreasedless thantheCPI, therebysuggestingthatreallabor
costs have been fallingthroughoutthisperiod. The biggestdifferencetook place
whenexchange rateswere undervalued(1982-87 and 1995-96). Inversely,when
the exchange rate was overvalued,prices decreased. Labor costs also decreased,
but not at the same rate; consequently,the gap between average labor costs and
pricesnarrowed.The effectof exchangeratemovementsin Mexico is symmetrical,
unliketheCanadian economy (Blecker and Seccareccia 2007).
The inverserelationshipbetween average labor costs and prices (induced by
exchangeratemovements)is a historicalfactof theLatin Americanregion,espe-

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 WINTER2008-9 97

ciallyinMexico.Referring totheexchangeratedevaluation thatoccurred inChile

and Mexicoin the1950s,J.Noyola(1957) explainsthattheywerefollowedby
lowerwagelevels,especiallyincountries wheretradeunionswereundergovern-
mentcontrol(as has beenthecase in Mexico,at leastsincethe 1940s).Hence,
politicalfactors
prevented labortoretainitspurchasing power,thereby leadingto
drasticchangesinthedistribution ofincome(Pivetti1991),characterizing indeed
a counterrevolution.
The threeratios(exchangeratemovements to producerprices,producerto
consumerprices,and laborcoststo consumerprices)together givean interest-
ingoverviewof theeffects of capitalinflowson prices(see Figure6). First,the
highercostsof externalinputs(causedby exchangeratedevaluation - ERI) are
fullypassedon toproducer prices(reflectedinthePPI), indicatingthatproducers
do notsubstituteexternalinputs.Second,thereis a fullpass-through effect from
producer toconsumer prices,whichdenotesthatentrepreneurs' margins arehighly
inelasticto changinginputcosts(Mott1998). Finally,laborcostsmoveless than
consumer prices.By neutralizing higherimportcosts,inflationis controlledand
entrepreneurs'profitmargins arestabilized.Hence,highercostsarepassedon to
consumers, whilelaborcostdecreaseskeepprofit margins unchanged.

and Interest
Movement
Exchange-Rate Rates

Another strikingfeatureof theMexicaneconomyis thatexchangeratedevalua-

tionsarefollowedbyhigherinterest rates(see Figure7). Thiscan be explainedin
termsofcentral bankauthorities' decisionstosupportfinancialcapitalgains,which
needtorecoverlosses,becauseofthedepreciation ofthenationalcurrency. Hence
interestratechangesareintended tooffsetcapitalgains/losses.
Moreover, higherinterest ratesmodifythedistribution of incomein favorof
capitalowners,demandis reduced, andtheeconomy stagnates.Also,importsdecline
andthecurrent accountdeficit shrinks(oratleastdoesnotincrease).Furthermore,
economicgrowth reducescredit,without affectingcommercial bankreturns,be-
causethespreadbetweentheTreasury bondratesanddepositratescontinues tobe
extremely high,as arefeesandcommissions. Undertheseconditions, thecentral
banksetstheinterest ratein a pro-cyclicalmannerto validatefinancialgainsand
affectindirectlyeconomicactivity.

Two ProblemsAriseWhenDevelopingEconomiesGlobalize

Althoughdevelopingeconomieshave undergone structural

important changes,
oftheircommercial,
andglobalization
suchas thederegulation andpro-
financial,
ductivesectors,twomainproblemsremain.Domesticinstitutionsarenotlinked
to productive and movements
activity in
of theexchangerateremainineffective
balancingtheircurrent
account.
Regarding ofdomesticfirms
issue,theintegration
thefirst firms
to foreign re-

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98 INTERNATIONAL JOURNAL OF POLITICAL ECONOMY

ducesdomestic spending oninvestment (see Levy2006a,2006b).Second,levelsof

creditworthiness
tendtorisebecausemoreunreliable localborrowers demandcredit
(smallandmedium domesticbusinesses thatoperate inriskier
sectorssuchas internal
markets andagricultural Third,financial
activity). margins increase,includingbank
commissions andfees,eventhough a lowervolumeofcreditis issued.Thus,invest-
mentspending ceases tobe thedeusex machinaofeconomicactivity andexports
becomethemaineconomic activity,
inducing hugeexternal incomeleakages(because
oftheincreasedlevelofimports) alongwithhighfinancial margins.
The secondobstacleforemerging countries is thatexchangeratemovements
do notbalancetheexternal currentaccount,becauseexchangeratedepreciation
induceslowerincomelevels to achievebalance-of-payment equilibrium. Ad-
exchangeratedevaluations
ditionally, are followedby higherprices(producer
andconsumer prices),lowerwages,andhigherinterest rates,thusmodifying the
distribution
ofincome.
Theneedtoattaineconomicindependence onceagainhasbecomea crucialele-
mentofdevelopment. Government intervention through fiscalpolicydeficits
aimed
atstrengthening
domestic production seemstheonlywayout,whichshouldbedone
withoutsubsidizingmultinational
corporations operating intheMexicaneconomy.
The dynamicproductive sectorsneedto be linkedto thedomesticeconomyand
shouldnotonlyrelyon low wagesin searchofan elusiveforeign demand.

Conclusion

The demandforcreditis theonlysourceof moneycreationin spiteof increased

externalcapitalmovements orgovernment openmarket External
operations. capital
inflowsrequiresterilizationif theyare unconnected to economicactivity (com-
pensation mechanism). Ifcreditdemanddoes notrise,themonetary base remains
relatively
unchanged andexternal capitalinflows lowernetinternalcredits.
Underfinancial globalization,interest ratesremainan administeredprice,the
mainobjectiveofwhichis toguarantee financialgains,whilepricestabilization
is
attainedthrough exchangeratestabilization policesandthewagebillis thebuffer
variablewhenever inflation
beginstorise.
Inflation
is determined by increasesin costsof production, whereimported
inputsareextremely relevant,as is imperfect market Undersuchcon-
structure.
marginsare protected.
ditions,profit Dependenceon theexternalsectorand the
lowcorrelation betweenexportsanddomesticproduction needsinducestructural
whichworsensas liberalization
inflation, grows.
Externalcapitalflowsin countries withhighforeign dependencealterprices,
whichthenprevent sustainedeconomicgrowth. Exchangeratedepreciation does
notinducehigher exportsnordoesitmodify thecomposition ofimports;itmerely
reducesimports, becausethereis no substitution betweenexternalanddomestic
production.Moreover, higher import costsleadtohigher consumer prices,thereby
erodingthepurchasing powerofworkers' incomeas theirrealwagesfall.Thisthen

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 WINTER2008-9 99

compresses domesticmarkets; yetentrepreneur's

profit
margins remainunchanged.
inglobalizedopeneconomies.
Thisis a viciouscyclethatis moreintensified

Notes
1. Itis assumedthatexternal savingsarecomplementary andnota substitute fordomestic
savings;therefore totalsavingswouldincrease.
2. Keynesdefendsa twofoldpositionon thisissue.In TheGeneralTheory, themoney
supplyis directly relatedtointerest ratesbyputting forward theidea ofan upward-sloping
moneysupplyschedule.However, inKeynes(1937),hearguesthatanaccommodative central
bankpolicyneednotmodify ratesas commercial
interest creditexpands.
3. Keynes'sdiscussionof moneyhoardingis disregarded, a view sharedby Minsky
(1975),whomodifies thedeterminants ofmoneydemand.
4. According toChartalism, centralbankmoneyis drivenprincipally bytheneedtopay
government taxes(see Wray1998).
5. As Le Bourvasays, It theretore seemsnecessaryto abandontheconceptot money
multipliers, whicharerelicsofthequantity theory of money, andto findanother technical
explanation forthedevelopment ofbankcredit"(1992,448).
6. The speculativemotivefordemandingmoneyis notemphasizedby honzontahsts
andcircuitists.
7. Kregel(ζυυζ) arguesthateversinceLatinAmericancountries acnieveatneirinde-
pendence, theyhavebeenopeneconomieswithgovernments adaptingtheireconomiesto
theinternational divisionoflabor.
8. KholdyandSohrabian (1990) present econometric
interesting workforindustrial coun-
tries,showing thattheexchangeratepass-through onwholesalepricesandconsumer
effects
pricesneednotbe equal,arguingthatifthelatterarenotfullyaffected, theexchangerate
pass-through effectis limited.
9. StallingandStudart (2006) showthatexternal capitalflowsintermsot GDP doubled
intheearly1990sinLatinAmerica.International bankloans,bondsandequitiesrepresented
20% ofGDP in 1995,but50% in 2003. In EastAsia,external inflows increasedonlyby6
percentage points(Stallingand Studart2006,table5-6, 126),whereasGDP growth rates
between1991-2000and 2001-2003 weremuchsmallerin LatinAmericain comparison
(3.3% against7.7% and0.4% to6.8%, StallingandStudart 2006,see table5-7, 128).
10. Different theoriesarguethattheavailability ofexternal currency is one ofthemost
important requirements foreconomicgrowth. Neoliberals,suchas McKinnon(1972), and
Gurleyand Shaw (1967), advocatethatexternalopenness,includingbanksand nonbank
financial institutions,wouldincreasesavingsandinvestment. Thisviewis basedon theex
antesavingtheory, whichassumesthatexternalcapitallimitseconomicgrowth.Kalecki
(1954b),basedon different assumptions, arguesthatexternalfinancecan limiteconomic
growth, whichcan be neutralized throughincreasingexportsthatwouldfinanceeconomic
development.
11. Rodnckarguesthat therewas moreprivatization, deregulation, andtradeliberal-
izationin LatinAmericaandEasternEuropethanprobablyanywhere else at anypointin
economichistory," withMexicocertainly at theverytopofthatlist(2006,974).

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