The Impact of External Capital Flows in Latin America

Lizzy Lozano

Center for International Studies

University of St. Thomas

Houston, Texas

Prepared for the delivery at the 82^nd annual meeting of the

Southwestern Social Science Association, New Orleans, Louisiana

March 27-31, 2002

Dynamic world changes in the context of globalization have forced inhabitants of the globe to adapt to new modes of action, ideals and perspectives on world politics. Perhaps the most profound change to date is the "post-World War II phenomenon known as globalization – the integration of national markets into an interdependent global market without borders" (Kegley and Wittkopf 2001, 247). Though the integration and interdependence of states’ economies was prevalent previous to the post-WWII phenomenon of globalization an increase in international trade and the fervent integration of world economies has caused much attention to be centralized on economic transactions within the international arena. (Skidmore and Smith, 1997)

Economic transaction in the context of capital flows is at present an imperative issue within the international arena. These changes do not only affect change on the political thought processes of individuals in the world, but also, the functioning of entities such as sovereign states, international institutions, and as my paper will emphasize, financial flows determinant by world market economies.

As sovereign states and international institutions along with market economies become ever more enmeshed and deeply integrated, globalization, by means of advanced technology, coerces governments to act quickly on policy reform. This type of quick reaction inevitably inhibits the exhaustion of all policy recommendations. My research looks at the relation between Latin American domestic policies and economic factors to explain historical trends in financial flows. Secondly, my research looks at the impact capital inflows have had on the Latin American economies, specifically in Mexico and Brazil during the 1990s to the present. Due to the extent of their possible impact, various types of capital inflow fare more attractive. Though, my research emphasizes the importance of all types of capital inflows to the Latin American region as being beneficial. Therefore, as international financial integration is further integrated during the age of globalization, Latin American governments throughout the region race to implement policies that attract foreign capital.

The first part of my paper will present in a chronological fashion from post-WWII (1945) to the present, world capital regimes, including those of Latin America, and its impact on capital flows to the region. Secondly, it will look at the change in volume, mobility, and composition of capital to the Latin American region.

The second part of my paper will discuss and present in a more limited scope, the effect of policy reform on capital flows to the Latin American region. I will further this research with case studies on Mexico and Brazil. This part of my paper is intended to provide a general understanding of the era between the 1930-1980s. The last part of this section presents the ultimate impact of capital’s volume, mobility, and composition as they continue to flow into the economies of Mexico and Brazil during the 1990s and 2000.

The closing section of my paper will recap historical trends in capital flows and suggest various policy implications that encourage capital flows to the Latin American region. I will also include within the closing of my paper how governments have and may continue to maintain control of capital inflows so as to reap the greatest benefits from such inflows without jeopardizing their positions as being investor credible.

Immediately following the devastations of WWII, world economic leaders, predominantly those from European countries and the United States, were faced with the task of devising and implementing a new international monetary system that aimed at economic recovery of the war torn nations. Therefore, the architects of such a system were also its greatest benefactors. This new monetary system was dependent upon a fixed exchange rate and consensus on the legislation and enforcement of its rule of law by its members and for its members. This international monetary system that was created in 1945, known as the Bretton Woods System (BWS), remained the international monetary system for over two decades until its demise in 1971. Under the umbrella of the BW regime emerged two other institutions, the World Bank (WB) and the International Monetary Fund (IMF). The latter currently serves as the dominant international financial institution that "promotes international monetary cooperation, free trade, exchange rate stability, and democratic rule by providing financial assistance and loans to countries facing financial crises" (Kegley and Wittkopf 2001, 269).

During the immediate post-WWII era, being the only member to sustain economic stability, the United States assumed the managerial position necessary for the successful functioning of the BW system. A highly valued American dollar backed by gold became the universal currency. "Backed by a vigorous and healthy economy, a fixed relationship between gold and the dollar (pegged at $35 per ounce of gold), and the U. S. commitment to exchange gold for dollars at any time (dollar convertibility), the dollar became as good as gold" (Kegley and Wittkopf 2001, 269).

Along with the multilateral decision to create the Bretton Woods regime, the U.S. unilaterally provided foreign capital to European nations in the form of aid through the Marshall Plan. American dollars were quickly transferred to the war torn European nations so as to rebuild their economies and currencies. The Marshall Plan also encouraged trade competitiveness within the Western European states to help strengthen their economies. Unfortunately, trade competitiveness was promoted at the expense of trade with the U.S. that simultaneously yielded a growing balance-of-payments deficit. Massive investments to both the European nations, approximately US$ 17 billion, and Japan were promoted to encourage a return to currency convertibility. As part of the plan for rejuvenating the European and Japanese economies, most of the world implemented protectionist policies while the U.S. supported them.

Further into the maturation of the system it was evident, as the universal currency, that the foreign holdings of the dollar increased thus, leaving the U.S. economy vulnerable to financial shocks as its currency reserves were being further depleted. "In any imploding national market, when one country’s currency reserves are depleted, it sets in motion panic abroad as investors reduce their holdings and the flight of capital brings down other countries in a chain reaction" (Kegley and Wittkopf 2001, 270). As a consequence inflation rose and by 1971 the United States trade deficit was approximately $2 billion. In the same year, President Richard Nixon announced that he would no longer honor "dollar convertibility" and thus was the fall of the BWS.

The international economic system was converted from a fixed exchange rate to that of a floating exchange rate. The exchange rate of the new system was to be determined by market forces and no longer by government intervention, as previously practiced by the United States. In sum, from the 1940s to the 1970s the U.S. as the world’s banker provided most of the international investment through direct investment. The Great Depression of 1929 caused both a drop in volume and change in composition from portfolio investment to that of direct investment for U.S. foreign investment. United States direct investment resumed its predominant status as it accounted for 60% of U.S. foreign investment by 1940. It steadily rose in 1950 and remained stable throughout 1960 and picking up by 1970 to about 70%. As a matter of fact, the U.S. was the dominant investor of foreign direct investment during the 1960s and early 1970s. "No other country came close; the next ranking holder of direct investment was the United Kingdom, at 18%, followed by The Netherlands, at 10% and France, at 6%" (Lipsey 1999, 12).

Foreign capital played a crucial role in the development and growth of the European and Japanese economies during this era. Once their economies and currencies were recovered it allowed for alternatives to the dollar, such as the Japanese yen. The return to currency convertibility of the European states and Japan served as a catalyst for the increased financial integration during the late 1940s and early 1950s. Aside from the return of these international actors, sovereign states, to the world economic arena, other actors have also emerged. Multinational corporations (MNCs) entered the world capital market in the 1960s while multinational banks (MNBs) dominated in the 1970s. The latter was specifically due to the rise in world oil prices during the early 1970s.

"International flows of capital perform a variety of functions in the world economy. They permit levels of domestic investment in a country to exceed the country’s level of saving. Inflows of foreign investment permit faster growth, and/or growth with less sacrifice of current consumption and they provide a means to invest where returns are higher than at home" (Lipsey 1999, 1). As Robert Lipsey explains, capital flows perform a variety of functions both long-term and short-term. A short-term examples provided by Lipsey include easing discontinuities within the economy and financing periods of great losses or destruction. Inflows of capital are not only beneficial during times of economic tension but also during times of growth. Recipient nations of external capital also benefit from technological innovation, capital formation, and the transfer of management skills, which also contributes to human capital.

Latin America has been the largest recipient of foreign investment throughout the 1990’s. This has specifically materialized in the form of foreign direct investment. In the latter half of the decade the region experienced a surge of foreign direct investment almost five times greater than in the first half, "from $36 billion annually in 1991 to $173 billion in 1997, according to the World Bank’s 2001 Global Development Report" (Litan, Masson & Pomerleano 2001, 1).

What have been the factors that have encouraged the surge in foreign capital to the Latin American economies? What contributions have been made by the inflows of foreign investment to the Latin American region during the 1990’s? Though the major vehicle for the increased mobility of capital has been the MNC, other financial firms, such as MNBs and insurers, have also contributed their share of foreign capital into the Latin American economies. From 1995 to the year 2000, the most prominent actor contributing to the increased flows of capital to the Latin American region has been the MNC.

To better understand the resurgence of external capital to the Latin American region is necessary to understand the evolution of world capital regimes and their relation to the capital regimes of Latin America. Equally important are the dynamic changes in capital’s volume, mobility and composition from the 1930s to the year 2000. The past two decades have not only seen a return to capital markets since the debt crises of 1982 but also a compositional change in capital as portfolio replaced direct investment in the 1990s. Then returning once again to direct investment by the year 2000.

During the BW era developing countries sought to establish their position as capital recipients to stimulate economic development. Unfortunately for the developing world, this including Latin America, the developed world expressed little interest in providing developing countries with the external capital they deemed necessary for economic growth and development. Thus, the World Bank directed all of its lending to the developed countries (Western Europe). Under stringent terms of conditionality minimal lending was directed to the less developed countries of the world.

Previous to the adoption of BW the world economy suffered the Great Depression of 1929. The Great Depression had bitter effects for the world but especially on the economies of the developing world, including the vulnerable Latin American region. Concurrent with such an economic blow, the entire region of Latin America faced a decline in Latin American commodity prices and the world’s demand of these products. Not only was the international demand for certain staple products such as coffee, sugar, metals and meat decreased but governments of Latin America also faced political pressures and social upheavals further threatening there economies. Political pressures faced by these countries were violent military coups and eventual militaristic regimes. Latin American governments optioned to respond to the economic and political havocs in two ways: first, to continue international market access to Europe and the United States second, to promote economic independence through industrialization. The latter was chosen as the best alternative and quickly promoted as the Import Substitution Industrialization (ISI) method. Most Latin American countries opted for ISI to protect themselves from external world shocks that their economies proved vulnerable to. They enforced greater integration amongst themselves but more specifically self-sufficiency.

Responding to the adverse effects of the Great Depression in 1929, governments of the Latin American region began implementing protectionist policies. The ISI model proved to be economically successful from the 1930s-1960s. The fundamentals of such a system was to produce manufactured goods that were previously imported from Europe and the United States. Proponents of the ISI model sought protectionist measures in order to rejuvenate their economies but in so doing capital controls were also set in place that restricted the inflow of foreign investment. Policy tools used by Latin America governments for the promotion of ISI were tariff barriers, price increases on imported goods, government subsidies on domestic products and the creation of state owned companies and domestic public investment. Thus, highly protective policies implemented by Latin American governments reversed the inflow of already lagging external capital.

As the ISI model further progressed it began to produce negative effects on the Latin American economies. A Latin American region that was once dependent upon the importation of capital goods (machine tools) to produce manufactured goods, now being domestically produced, realized that the decline of its economy was due to the pillars of the ISI model, self-sufficiency and industrialization enforced through protectionist measures. The success of the ISI model depended on capital goods that were now too expensive to import because of protective policies implemented in the initial phases of the ISI model.

The need for capital goods to sustain the ISI model and its rising costs became more profound for the following reasons; declining prices of principle exports, a Latin American domestic market cap, and intense domestic investment on technological machinery. These factors of ISI exasperated contentions with the economic situation of Latin America as the unemployment rate increased and purchasing power decreased. Investment was dumped into machines and capital goods causing a decline in the need for manual labor.

As the success of the ISI model deteriorated, militaristic authoritative regimes became the mode of government throughout Latin America. An increased resistance toward organized labor and cuts in federal spending, as part of the stabilization programs, dominated the political economy of many Latin American countries. In fact, stabilization programs became typical modes of militaristic government control over national economies. These militaristic regimes also referred to as bureaucratic authoritarian governments aimed "to revive economic growth by consolidating ties with international economic forces – revising, once again, the terms of dependency on the global world –system" (Skidmore and Smith 1997, 58).

Though these militaristic regimes aimed to stimulate economic growth through economic policies of stabilization and world market access such governments were perceived as politically unstable. High capital controls from the previous economic regime and the lack of investor credibility disenchanted investors to send monies to the Latin American region. Thus, access to external financial resources remained limited.

Aside from efforts in establishing credit and relations with international creditors, such as the United States, European banks, the World Bank and the IMF the "1970s brought about a change in which international private liquidity increased" and the economic growth of Latin America became dependent on external financing. External financing during the 1970s was heavily provided in the from of recycled petrodollars. (Edwards 1999, 9)

A rise in oil prices during the early part of the 1970s allowed for the recycling of petrodollars that began to enter Latin America. Middle Eastern countries unable to spend their profits earned from the increase in world oil prices invested their "petrodollars" in international banks particularly those in the United States and Europe. In turn these banks sought to lend or re-invest this money out to "capital starved but credit worthy clients – at profitable interest rates" (Skidmore and Smith 1997, 58). Hence the term "re-cycled" petrodollars. The Latin American countries quickly assumed the role as credit worthy and profitable clients.

As borrowing and lending to these countries increased so did the debt of these countries. The increased external financing further plunged the region of Latin America "into a decade long economic crisis" in the 1980s (Edwards 1999, 9). Mexico’s announcement in 1982 that it was unable to meet its payments was the pre-condition setting the stage for the region’s economic collapse of the 1980s. This era is often referred to as the "lost decade." "Capital flows turned into capital flight and in the later part of 1982 and early 1983 countries began to loose access to international financial capital markets" (Edwards 1999, 9).

The 1982 debt crises transformed Latin American countries from capital recipients to capital exporters. In the latter half of 1989 Latin America again transformed into a target region for capital investment. During this period, Mexico was noted as the greatest recipient of capital inflows (approximately US$2 billion). The table below shows the type of flows that entered Latin America prior to the debt crises (1978-1981) and after the neoliberal era, which is discussed in the next section. As is visible by table 1, following the debt crises, capital flows dropped significantly. By the 1990s they returned to Latin America but in the form of portfolio investment.

TABLE 1. The Composition of Capital Inflows to Latin America, 1978-1995

Source: Bosworth and Collins, 1999

Between 1982-1989, Latin American governments pursued deals to reduce their debt with private creditors. "The Brady Plan improved Mexico’s ability to service its external debt by reducing the interest and principle payments it had to make" (Dornbusch and Werner 1994, 257). Macroeconomic policies undertaken by the Mexican government along with the reduction in world interest rates have also restored their positions as recipients of capital, specifically from the United States, the IMF, and the WB. These international authorities imposed stringent terms of conditionality on Latin American borrowers to relieve themselves from debt burdens. The reforms set forth by international institutions such as the IMF were referred to as neoliberal ideas and their proponents as neoliberalist.

Neoliberalism included reforms such as macro-adjustment through the promotion of freer market economies implementing lower barriers to trade and investment. Structural reforms of domestic economic policy called for a reduced government role and more importantly efforts to reduce inflation. As referred to by the IMF, "new monies" were allocated to countries that embarked on these terms of conditionality, approximately US$20 billion. "In 1988, capital was still flowing out of Mexico; in 1989, inflows barely reached $0.9 billion. But by 1992, two years after the Brady Plan, they amounted to almost $26.5 billion; and in just the first three quarter of 1993, capital inflows totaled $22 billion" (Dornbusch and Werner 1994, 258).

The smaller countries of Latin America were the first to implement neoliberal policies during the 1970s (Argentina and Chile). The Mexican and Brazilian governments did not implement neoliberal reform until the late 1980s and mid-1990s. A region once characterized by high inflation now began to experience a significant drop in inflation by the early 1990’s. In 1989, closing the decade of economic crisis, inflation was at an astounding 130% but by 1994 it had dropped to 14%. This dramatic drop in inflation allowed for international investors to start looking towards Latin America.

Portfolio Investment

The inflow of external capital to Latin America from Europe, Japan and the United States increased "from only $13.4 billion in 1990 to the impressive total of $57 billion in 1994" (Skidmore and Smith 1997, 60). According to Bosworth and Collins, table 1, the return of external capital to the Latin American region in the 1980s took the form of portfolio investment as it increasingly replaced direct investment. Unfortunately for Latin America, portfolio investment as equity, stocks, and bonds leave countries as quickly as they enter. As perceived by the Latin American governments, portfolio investment proved to be highly mobile and volatile.

The compositional change from direct investment to portfolio investment during the early 1990’s once again allowed for the Latin American economies to exhibit the vulnerable state of their economies in the face of world externalities, particularly with the increase of U.S. interest rates. This increase in U.S. interest rates led to a reversal of capital inflows to Latin America.

The Brazilian economy in the mid- to late-1960’s and early 1970’s always experienced the down times of high inflation. With the accession of Joao Goulart as president in 1961 he faced the problem of rising inflation. "By 1963 inflation and the balance-of-payments deficit had grown even more difficult to deal with" (Skidmore and Smith 1997, 180).

To deal with this growing problem President Joao Goulart implemented the Dantas-Furtado plan headed by the strong intellectually recognized politician Santiago Dantas and experienced economist Celso Furtado. The U.S. government along with the IMF worked together with Brazilian economic officials to implement the stringent terms of the Dantas-Furtado Plan. Such terms included wage controls and credit reductions in hopes of winning foreign creditors’ confidence. (Skidmore and Smith 1997)

During the late 1960s the military regime tackled inflation through indexation. The Brazilians continued their standard of living, despite inflation, by promoting industry with the ISI model. A strong supportive public sector further strengthened the Brazilian economic model to provide the economy with the necessary growth to establish international credibility. (Dornbusch 1997, 370)

Under military rule the presidency of General Humberto Castello Branco in 1964-1967 implemented a stabilization program designed to encourage private savings and industrial investment. As the Brazilian economy continued to suffer from high inflation and a balance of payments deficit, economic stabilization called for tight monetary and fiscal policies that cut labor wages and access to domestic credit as well as increased tax collection and prices on public outputs.

Heading Branco’s economic team were Bulhoes and Roberto Campos. The team displayed great commitment to austere measures of economic reform. Newly accessible credit was provided to Brazil by international financial institutions such as the IMF, WB and the U.S. government. To further encourage investor credibility the Brazilian government also created the ORTN (Readjustable Obligation of the National Treasury), which recovered the Central governments capacity to borrow. (Armijo 1993, 269)

The deepening of the Castello Branco government’s stabilization program was the eventual cause of a governmentally induced recession that ultimately hurt small business firm’s capacity to borrow much more than the multinational corporation’s. Thus, in order to counter such effects the government passed laws to stimulate domestic and foreign investment with the creation of a central bank, BACEN. Brazilian economic policy also included other laws that enabled easy access to foreign capital. The adoption of Resolution 63 allowed BACEN access to external capital. In turn, BACEN, would then loan the newly acquired capital to domestic industry through Law 4131. (Armijo 1993, 268-271)

Under militaristic authority, the presidential administrations of Arthur da Costa e Silva (1967-1968) and Emilio Garrastazu Medici (1968-1974), sought to decentralize and segment the country’s political economy to encourage long-term credit and investment. Another central focus was on the controlling of interest rates. Economic minister Antonio Delfim Netto’s (1967-1974) economic reform, which eliminated BACEN, expanded credit, and "recontrolled interest rates, as well as some prices," allowed for the Brazilian economic miracle that lasted from 1968 to 1973. Antonio Delfim Netto, an advocate of economic growth through export growth and diversity, emphasized the importance of the export sector by supporting an economic system based on a "crawling peg" that initiated frequent mini devaluations in 1968. (Armijo 1993, 272)

During this era of high growth within the Brazilian economy, President General Ernesto Geisel began a political move towards democracy. The Geisel Administration (1974-1979) enjoyed the benefits of the "Brazilian Miracle" but by the close of the decade international petroleum prices and inflation rose over 100 percent and the greater state role that the Geisel Administration pushed did not suffice. The impact of both factors further depressed Brazil’s economy and enlarged the country’s already rapidly growing deficit. As a major importer of oil the Brazilian economy suffered greatly from the oil shocks of the 1970s. (Armijo 1993; Dornbusch 1997; and Skidmore and Smith 1997)

Further crippling the Brazilian economy was President Ernesto Geisel’s postponement of domestic economic adjustment on price increases of oil products. Instead financing was made possible by a growing external deficit. "The boom years for private industry (1964-1980) easy access to inexpensive BNDES credit and foreign loans, along with state intervention and support via extensive fiscal incentive ultimately ended in 1980. Two years into the decade the world recession’s toll on the Brazilian economy further "depressed the value of Brazilian exports, while high interest rate kept the cost of servicing the foreign debt at a crippling level" (Skidmore and Smith 1997, 185). In 1982 Brazil was officially recognized as having the largest foreign debt in the world and opted for a stabilization plan created by the IMF to save their economy from near collapse. Brazil, like most of Latin America was facing the adversities of high inflation and growing debt. (Skidmore and Smith 1997, 185)

The Mexican economy also faced the problem of rising inflation and a growing foreign debt. An initial sign that Mexico would embark protectionism was the implementation of restrictive policies in financial legislation. The 1973 Law to Promote Mexican Investment and Regulate Foreign Investment reduced the inflow of foreign direct investment, "which had increased at an average annual rate of 10 percent between 1959 and 1970, grew only 4 percent annually from 1971 to 1976" (Gurria 2000, 190).

Though foreign direct investment decreased, the boom of the Euromarket along with the recycling of petrodollars allowed for the steady inflow of external capital that Mexico was receiving. Thus, the Mexican government promoted public spending and abandoned stabilization programs initially influenced by international creditors. Like most of Latin America, Mexico relied on foreign debt to support its increased public spending, by which foreign debt grew annually at a rate of 28 percent between 1972 and 1982.

In regards to the Brazilian economy, prior to the Latin American debt crises of 1982, Brazil implemented a series of unsuccessful stabilization plans to control and reduce inflation. By 1985 annual Brazilian inflation doubled to 200% from its previous recorded estimate of 100% in the early 1980s. Stabilization plans implemented in the second half of the 1980s and throughout the 1990s were the Cruzado Plan, Plan Bresser, Collor Plan and the Real Plan. The Real Plan is the current plan initially implemented in 1995. (Dornbusch, 1997)

Though both countries were experiencing excessive inflation it was not the only factor contributing to the debt crises. Another factor that contributed to the debt crisis that Latin America would suffer from in the early 1980’s was capital flight. Total Mexican assets held abroad increased by approximately US$ 26 billion from 1973-1982. In countering the high mobility of capital, as mentioned above, Mexico implemented the 1973 Law to Promote Mexican Investment and Regulate Foreign Investment, which increased barriers to trade and investment. "The deterioration of public finances, inflation, capital flight, and the external imbalance, in addition to the sharp reduction in private investment, led to a devaluation of the Mexican peso on August 31, 1976" (Gurria 2000, 191). These have all been recognized as equally contributing factors to the debt crisis in 1982.

An overvalued peso during Echeverria’s presidency was fixed to a pegged exchange rate of 12.5 pesos to the dollar in 1976. Later that year the Mexican peso was devalued by 60 percent. A month later the peso was again devalued by 40 percent. President Echeverria continued currency devaluations in effort to reduce the foreign debt. The "basic objectives of the Echeverria administration were growth with equitable distribution of income, strengthening public finances and state-owned enterprises, reorganizing Mexico’s international economic relations and reducing foreign debt" (Maxfield 1993, 249).

By 1976, inflation had increased by 10 percent to 30 percent from the 1973 measure of inflation at 20 percent. With inflation on the rise and a growing deficit the Mexican economy did not look promising to foreign investors. Thus, Jose Lopez Portillo, the new Mexican president (1976-1982), focused all of his attention to restoring investor confidence in the Mexican economy. Upon Portillo’s ascension to the presidency, Mexico discovered an abundance of a very lucrative resource, oil. Unlike Brazil, an oil importer, Mexico became an oil exporter. "Exports grew and world prices mounted, however, and Mexico’s petroleum earnings jumped from $500 million in 1976 to more than $13 billion in 1981" (Skidmore and Smith 1997, 253). Despite the financial boost fueled by a newly discovered commodity, 1982 inflation continued to plague the economy as it was then measured at approximately 60 percent. A drop in world oil prices in 1981 caused the Mexican economy, which was now heavily dependent on oil revenues, to continue its dependency on foreign borrowing.

As previously mentioned, a drop in the world’s oil prices, an increase in world interest rates, excessive capital flight and Mexico’s growing foreign debt led to the Latin American debt crises of 1982. It was in this year that Mexico officially announced its inability to pay its foreign external debt, estimated at US$80 billion. The affects of such an announcement further caused the Mexican economy to decline as "all types of inward investment into Latin America declined after the 1982 currency crisis" (Lipsey 2001, 3). Capital flows entering the Mexican economy during the 1970s were in the form of re-cycled petrodollars. As recycled petrodollars fueled foreign investment to the Latin American region in the form of commercial loans during the 1970s, external capital increasingly took the form of portfolio investment throughout the late 1980s and early 1990s. Though direct investment flows decreased after the 1982 currency crisis, as did all inflows, they remained positive unlike other forms of investment that decreased or even reversed. (See table 1)

The most dramatic change of flows were evident in the volume of portfolio investments, "net portfolio investment flows turned negative in 1983 as outflows exceeded inflows" (Lipsey 2001, 3). Reacting to the decline and even outflow of capital Mexico’s banking sector was nationalized to counter the negative effects of losing access to world capital markets thus forcing the government to opt for domestic financing of its deficits (Gaston &Warner 2002, 3).

Following the Latin American debt crises of 1982, the second half of the decade was characterized by tight monetary and fiscal policies. A non-orthodox stabilization program and a more open market oriented economy aimed to reduce inflation and attract foreign capital needed to stimulate domestic growth and access to the international financial arena. Features of the program initiated in 1987 by Mexican President de la Madrid included the following:

• The nominal exchange rate was fixed and subsequently a crawling peg was put into effect.
• To reduce fiscal imbalances, fiscal policy focused on rigorous control of expenditures, tax reform to increase revenues, realignment of prices of goods and services produced by the public sector, and a comprehensive process of divestiture of public enterprises.
• A restrictive monetary policy was implemented to contribute to the stabilization of aggregate demand.
• Import duties were reduced and the import permits system dismantled in order to consolidate the goal of a more open economy.
• A system of political consensus, called the "Pacto," was instituted, which allowed the settlement of key prices through negotiation and mutual agreement among the representatives of key economic agents (unions, farmers, government, and private entrepreneurs). (Gurria 2000, 193-194)

By 1989, Mexico’s stabilization program succeeded in reducing inflation, "from 159 percent in 1987 to 20 percent in 1989" and creating an environment of stabilization which allowed for the resurgence of external capital in the same year.

External factors also played an important role in attracting new foreign capital such as, "a reduction in international short-term real interest rates, the recession in industrialized countries, the deterioration of the terms of trade that exacerbated Mexico’s current account deficit, in the presence of a broad supply of external funds, and changes in U.S. capital market regulations" (Gurria 2000, 194). Other factors include macroeconomic and political stability, sector specific incentives and increased market economies that focused on liberal trade policies. (Agosin 1997, 1-3; Gaston and Werner 2002, 1)

As evident through such measures of reform, by the mid-1980s a new wave of ideals began to dominate the economical and political arena. Economic reform within the Mexican economy aimed at stabilization and structural reform through a market oriented economy. Neoliberalism began to take form within Mexico as President de la Madrid implemented new policies that further cut government spending, privatized state-owned companies and further reduced trade barriers, especially by the liberalization of capital mobility, to implement a more commercially oriented economy. It was during the era of neoliberalism that Mexico realized that post war systems of intense protection such as the ISI model were beginning to lose their attractiveness and even worse proving detrimental to the overall state of the Mexican economy. With the accession of Salinas de Gortari in 1988, the neoliberalization process was further carried into the 1990’s. Though structural reform was initially implemented in 1983 with President de la Madrid, greater efforts were implemented during Salinas’ administration. President Salinas’ neoliberal reforms focused on six policy areas:

1. Trade liberalization,
2. Liberalization of foreign investment,
3. Privatization of public enterprises,
4. Economic deregulation,
5. Transformation and modernization of the legal framework of Mexico’s land tenure system, and
6. Regulation of monopolistic practices through the promulgation of a new Federal Antitrust Law. (Gurria 2000, 202)

Protectionism expressed through the postwar model of ISI was ultimately abandoned. "Salinas and his team kept lowering trade barriers. They aggressively promoted privatization of state-owned industries, even putting up for sale such sacred cows as the telephone company and the banking industry (nationalized by Lopez Portillo in 1982)" (Skidmore and Smith 1997, 257).

In response to President Salinas’ financial reform and external factors such as low interest rates in the U.S., the early 1990 received massive amounts of capital inflows. New methods of finance within the international financial system, such as reduced risks through portfolio investment, provided investor incentive. The growing popularity of neoliberal reform was the change in mentality from a negative view of foreign investment, which dominated the post-WWII economic policy up until the 1970s, to a positive view of foreign investment in the mid-1980s. Another factor contributing to the inflow of foreign capital to Mexico in the early half of 1990 was that private borrowing appeared more appealing than public borrowing.

The assumption that private borrowing was better than public borrowing was also a factor for the lending boom of the newly privatized commercial banks. "Banking credit to the private sector went from less than 10% of GDP in 1988 to almost 40% in 1994" (Quiroz 2001, 204).

As Mexico approached the 1990’s its economic state appeared prospectful, gross domestic product (GDP) increased and inflation decreased, thus encouraging greater inflows of capital. The compositional makeup of capital inflows between 1990 and 1993 entered as foreign direct investment and portfolio investment. "Of the total amount of capital inflows for 1990-1993, direct foreign investment accounted for 18 percent and portfolio investment for 54 percent" (Gurria 2000, 196).

By 1992 Mexico began negotiations about integrating its economy to its Northern industrial neighbor, the United States. In an effort to attract foreign investment from the industrial worlds, the U.S., Europe, and Japan, President Salinas and his administration negotiated a free-trade pact between Mexico, the U.S. and Canada in 1992, known as NAFTA. "NAFTA opened Mexico to U.S. investment, in various ways. Under the treaty U.S. banks and securities firms could establish branch offices in Mexico and U.S. citizens could invest in Mexico’s banking and insurance agencies" (Skidmore and Smith 1997, 258). The NAFTA accord was officially adopted in 1994 with the newly elected president, Ernesto Zedillo Ponce de Leon. But along with the adoption of NAFTA social, political and economic pressure loomed thus, negatively affecting the international image of Mexico. The first problem to arise greeting President Ernesto Zedillo was the guerilla movement in Chiapas, secondly was the large outflow of capital by international investors. "Fearful of the overvaluation of the peso, investors withdrew more than $10 billion from Mexico within a week" (Skidmore and Smith 1997, 261). Politically, Mexico was experiencing assassinations of political figures and the public’s disapproval of a PRI administered government. As the mid-1990s experienced recession it was evident that Mexico would have to depend on the aid of international institutions to pull them out of their economic bind. (Dornbusch and Werner 1994; Skidmore and Smith 1997)

Brazil’s implementation of neoliberalism did not take force until the mid-1990s. In 1990 Fernando Collor de Mello assumed the Brazilian presidency. As previous administrations, the Collor Administration pursued economic stabilization by enforcing tight monetary and fiscal policy. "His program relied on such short-term gimmicks as the freezing of financial assets and the immediate abolition of indexation. Both proved ineffective after only a few months. Collor also ordered the massive firing of civil servants, hoping to reduce the swollen government payroll and thus gain fiscal relief" (Skidmore and Smith 1997, 187).

Almost a decade after Mexico, Brazil’s political scene was also introduced to a new wave of ideas known as neoliberalism. As a neoliberalist, President Fernando Collor, implemented policy reform that would, too far into the future, be beneficial to the Brazilian economy. "An ambitious plan of neoliberal reforms included privatization, deregulation, and opening of the economy through lower tariffs. The governments single victory in this sphere was the sale of a major state-owned mill, which greatly increased its profits and productivity once in private hands" (Skidmore and Smith 1997).

President Fernando Collor was later impeached in 1992 and succeeded by Vice President Itamar Franco. The presidential administration of Itamar Franco lacked political direction, though his gravest threat was the state of the economy. Once again inflation rose to unprecedented levels by 1993. Inflation rose as high as 2490 percent but by 1993 President Itamar Franco appointed Fernando Henrique Cardoso as finance minister. Anti-inflationary measures were implemented by the new economic team headed by Cardoso whose successful stabilization program led to his eventual Brazilian presidency in 1995 (Skidmore and Smith 1997, 187-188).

As noted during President Ernesto Zedillo’s administration, increasing capital flight led t the Mexican Peso crises of 1994. This initiated the drying up of capital inflows throughout Latin American in the early quarters of 1995. The term "Tequila Effect" has been applied to the reaction of foreign investors immediately following the peso devaluation in 1994. Jeffrey Sachs best describes the reaction of international creditors who withdrew and transferred capital investments from the Latin American region, "investor panic spread contagiously from Mexico throughout emerging markets" (Sachs, Tornell, and Velasco 1996, 147).

Mexico appears to have been a prime example of a country to experience economic crises. There are explicit factors used by economist when determining a country’s financial risks environment, "a real exchange rate appreciation during the capital inflow period, indicates a greater risk of currency depreciation and when capital inflows suffer a reversal, not only do gross inflows dry up, but also, holders of liquid domestic liabilities try to convert them into foreign exchange and flee the country" (Sachs, Tornell, and Velasco 1996, 150). According to Sachs, Mexico met both preconditions for economic crises, currency devaluations and massive capital flight. Simultaneously, as Mexico experienced a large appreciation of the exchange rate and guerilla movements in Chiapas, international investors perceived the country as politically and economically unstable, thus, fearing the risks of currency devaluations, massive capital flight turned into the Mexican Peso Crises of 1994.

"As a result of the adjustment plan devised after the peso devaluation by the Ministry of Finance, headed by Guillermo Ortiz, interest rates hit 110 percent, inflation reached 52 percent, unemployment doubled and GDP decreased" (206). Though President Salinas’ plan stabilized the economy, by 1994 it damaged the banking system. The Mexican Peso crises of 1994 called for the intervention of the government in order to bailout the banking system. The government opened the banking sector to foreign investment through mergers and acquisitions. In 1994, President Salinas only opened up the financial system to foreign investors partially. They were not allowed to own a majority of any domestic bank until the collapse of the peso in 1995. Then foreign firms were allowed full ownership of domestic banks.

Though the region as a whole experienced a surge of capital inflows, specifically FDI has been heavily concentrated to the Latin American countries of Argentina, Chile, Colombia, and Venezuela while simultaneously being sector specific. The largest recipients of FDI have been Mexico and Brazil, specifically since 1995 to the year 2000. Both countries have also experienced a change in the destinations of capital flows from traditional sectors such as the manufacturing sector to new sectors such as the services and financial industries.

The change in attitude toward foreign investment has allowed for the wave of neoliberal policies that the Latin American region began to implement in some countries during the 1980’s but more extensively in the 1990’s. Contributions provided by foreign capital have included technological advancement, managerial expertise (entailing risk management) and increased access to world markets. Upon realization of the benefits to be gained from foreign investment economic legislation has been further liberalized in such a manner to maximize the benefits of capital inflows. Such policies adopted have included national treatment, privatization processes, debt conversion and regionalization. (Litan, Masson & Pomerleano 2001)

Pro-market economic reform throughout the Latin American region in the context of neoliberalism is reflective of the new attitude towards the inflow of external capital. Unlike the restrictive laws of the 1970’s, that discouraged foreign investment through capital controls, liberal policies of the 1980’s have encouraged capital inflows. Foreign investment was greatly reduced during the first half of the decade due to "the increased country risk associated with the debt crises and the region’s impaired prospects for growth" (Agosin 1995, 4). But, shortly after the debt crises many Latin American countries began implementing policies to liberalize trade and investment so that by the end of the decade such reform proved successful as the inflows of capital returned to the region.

There have been two radical changes within the liberalization process of Latin America that significantly increased the inflow of foreign capital to the region. The first entailed reforms that affected the activity of multinational corporations, the major vehicles of capital flows. Most Latin American countries have granted national treatment to subsidiaries of multinational firms allowing them to enjoy the same benefits as domestic firms. This has included benefits within the tax arena being as subsidiaries are now taxed as domestic firms.

Secondly, the liberalization process has also included the issue of foreign capital repatriation and profit remittances abroad. Liberalizing the activities of multinational firm’s are indeed factors that encourage the inflow of foreign investment. Other mechanisms for attracting foreign capital have been through debt capitalization and privatization processes.

The most recent achievement of the neoliberal process in attracting new foreign investment has been with the privatization process of public services, such as within the telecommunications, energy, and financial services sectors. Privatization has helped to encourage greater productivity thus promoting competition in the world market.

Most countries within Latin America promoted the liberalization process from the mid- to late 1980s and even as early as the 1970s (for example in the cases of Argentina and Chile). "External debt capitalization programs have existed in Argentina since 1984. Through mechanisms of this type, a significant portion of foreign capital was invested in Argentina ($718 million out of a total FDI inflow of $3,918 billion) from 1984-1989" (Agosin 1995, 12). Chile is another sample country that used debt capitalization in attracting foreign capital since 1985. Though neoliberal reform within Chile began as early as 1974 with Decree Law 600, which attracted foreign investors by relaxing tax laws and time limits on profit remittances in regards to FDI, capital inflows following neoliberalism did not materialize until the late 1980’s and early 1990’s.

Mexico has also showed a recent interest within the last two decades in the liberalization of FDI policy. Up until the mid-1980’s economic policy toward capital inflows limited the volume and penetration of foreign investment into the Mexican economy by implementing foreign ownership caps of public enterprises as well as totally excluding foreign ownership participation in various sectors. Authorization requirements for FDI were approved on a case-by-case basis and a 49% ceiling was placed on enterprises’ capital. "Laws on foreign ownership passed since 1984 have admitted FDI into new areas previously reserved for the government or domestic enterprises (petrochemicals, financial services, telecommunications)" (Agosin 1995, 16).

These liberal policies were greatly promoted during the Mexican administrations of President de la Madrid (1984) and President Salinas (1989). Furthermore, the 49% ownership cap was replaced by 100% foreign participation in 1989 on investment valued at less than $100 million.

In 1986 Mexico began using the debt conversion program to attract foreign capital. By 1990 "one-fourth of all FDI in Mexico was attributable to the debt conversion program" (Agosin 1995, 16). Most FDI during this era was routed to projects regarding privatization, technological advancement and the export sector, thus making its greatest investment within the manufacturing sector (auto industry). Debt conversion mechanisms to reduce country risk and ensure investor confidence have also been used in Argentina, Chile, and Brazil. Debt conversion mechanisms, privatization, and market-oriented policies have all encouraged foreign investment and access to world markets. These types of reforms within fiscal and trade policy have played significant roles in accessing foreign capital.

Along with Mexico, the entire Latin American region experienced an inflow of foreign capital. This is due to the liberalization of foreign investment policies during the latter part of the 1980s. Reasoning behind Latin American neoliberalism were the potential contributions for growth and development. Contributions to be gained from the new inflows of FDI include technological advancement, management techniques and access to foreign markets. Aside from domestic neoliberal policies, another factor contributing to the increased inflow of foreign capital has been the market potential of individual countries and the region as a whole. Latin American countries have encouraged freer markets and openness to trade in order to attract foreign capital. Regional agreements within Latin America, such as NAFTA and Mercusor, by Mexico and Brazil respectively, have served as catalyst for foreign investment in the 1990s.

The following table (table 2) exemplifies the volume of foreign direct investment from the 1990s to the year 2000 (estimated average by ECLAC). As stated above due to the neoliberal process of the late 1980s, the Latin American region received a huge inflow of direct investment. In the example of Brazil, inflows increased significantly between 1995 and 1996 due to privatization programs of neoliberalism.

Source: ECLAC 2000

Again in implementing these policies Mexico is perhaps the greatest example. The MNC has been a primary vehicle for foreign investment, especially of foreign direct investment, within the Latin American region. In fact financial activity by MNCs has increased greatly in the second half of the 1990s largely due to the adoption of NAFTA in 1994. "The tremendous surge in FDI in Mexico has been the result of the following three factors (listed in order of importance): the changes in FDI policy since 1984, the reduction of country risk (associated with the renegotiation of the debt), and the economy’s new increased openness to inflows of world trade" (Agosin 1995, 23).

According to Agosin there are contributions to growth and development that by FDI are tangible, such as capital, and intangible, such as access to world markets and the development of human capital. Many Latin American countries have abandoned long-standing protectionist policies that were characteristic of post-WWII economic policies and have now opted for policies that seek to maximize the contributions of external capital. Latin American governments have begun to realize the counter production of capital controls on all types of investment weather they are short-term or long-term. Though equity flows which have increasingly grown in percentage of total flows to Latin America in relation to direct investment and have proven to be more volatile than direct investment, capital controls on equity flows may still prove counter productive. "One reason capital controls on short-term capital may be counter productive is that the flows they discourage may contribute to growth. Moreover, it is difficult to assess the effectiveness of a policy, such as the imposition of various categories of capital controls, without calculating the cost including the cost in lost growth, if any" (Gruben and McLeod 1998, 288).

Foreign direct investment’s contribution to gross investment in various Latin American economies has been substantial due to the debt conversion programs of Mexico (1986-1989) and the privatization process of Brazil (latter half of 1990s). Foreign direct investment allows for capital formation and higher consumption without straining real income.

Foreign direct investment has also been sector specific in regards to its contributions. The internationalization of Mexico’s economy since the 1980’s have yielded an increase in the exporting of manufactured goods and services. Thus, the export market within the Mexican economy has been a large recipient of foreign investment during the 1990s. "The country’s increasing integration into the North American regional market (NAFTA) has stimulated investment for export markets, especially by TE’s" (Agosin 1995, 24; ECLAC 2000; United Nations 2000).

Beginning the first year of the decade in 2000 foreign direct investment flows to Latin America were greatly captured by Mexico and Brazil in relation to the rest of the region. Mexico and Brazil accounted for two thirds of the total inflows of foreign direct investment while their total share of FDI in the second half of the previous decade was slightly more than half of total FDI flows to Latin America. This buoyant trend in FDI to Mexico and Brazil has been the response to liberalization programs during the 1990s.

As with the rest of Latin America during the 1990s Mexico also began to liberalize FDI regulations. In addition to Mexico’s liberalization process during the 1990s, the Mexican government, as noted above, also pursued greater regionalization with the adoption of the NAFTA Agreement in 1994. Geographical proximity to the North American neighbor enabled the country to easily adopt the NAFTA Agreement ultimately integrating both economies. The adoption of NAFTA and other economic policies governing foreign investment, such as national treatment and rules of origin, have all encouraged foreign investment into the Mexican economy.

Another characteristic of foreign capital flows to Latin America during the second half of the 1990s and the opening year of the new decade were the destinations of such flows. Unlike previous years, foreign investment during this era was directed towards the manufacturing and export sectors within the Mexican economy. "More than 60% of overall FDI between 1995 and the first semester of 2000 was directed at the manufacturing sector" (ECLAC 2001, 38). External capital invested in the manufacturing sector from 1990 to 1999 increased Mexican exports to their North American neighbor so that "Mexico increased its motor vehicle imports into the United States from 5% to 14%, and its share of electronic imports into the United States from 13% to over 20%" (ECLAC 2001, 39).

Aside from the huge inflows of foreign capital received by the manufacturing sector (46%) in 2000, other Mexican industries also received substantial amounts of foreign investment. Recipient sectors of FDI in 2000 were the financial and commerce sectors. They received 31% and 16% of total FDI in the first half of 2000 respectively. Sectors that have not been fully privatized such as the service sector (gas, electricity and telecommunications) and the oil sector remain closed to foreign penetration thus, receiving limited amounts of foreign investment. "For foreign involvement in these industries, certain institutional restrictions are in force: either the industry remains largely in the public sector or the foreign share in it is limited. In telecommunications, with the exception of cellular telephony, foreign participation is restricted by law to 49% of the total, and TELMEX, the former state company maintains almost a monopoly over local service and controls the interconnection infrastructure" (ECLAC 2001, 43).

FDI flows into the Mexican economy in 2000 have continued the trends of 1990. The manufacturing sector remains the largest recipient of foreign capital, specifically within the automobile and electronic industries thus, contributing to Mexico export growth especially to the United States. New foreign investments in 2000 have been made in the financial and commerce sectors while other service sectors such as telecommunications and electricity remain highly restricted.

The following page displays two graphs that represent the destinations of capital flows. Though it is evident that, traditional sectors (manufacturing sector) remain dominant recipients of external capital, new sectors (financial, commerce and service sectors) have become more attractive to foreign investors. According to data provided by ECLAC, the greatest recipient of external capital has been the manufacturing sector. Between 1995-1999, the manufacturing sector received over 50% of total direct investment, though dropping in 2000; it remained the dominant recipient of capital, receiving approximately 46% of total direct investment. Because of such high inflows to the manufacturing sector, Mexico, specifically the auto and electronic industries, have experienced significant export growth to their North American neighbor.

"Between 1990 and 1999 Mexico increased its share of motor vehicle imports into the United States from 5% to 14%, its share of electronic imports into the United States from 13% to over 20%" (ECLAC 2001, 39). Another sector that has increased its exports from Mexico to North America has been within the textile industries. Between 1990 and 1999, wearing apparel exports increased from 3% to 13%. This growth in exports is the response to NAFTA and trade liberalization incorporated into the agreement. Mexico has also benefited from the maquiladora program, which has provided employment generation. In 1996 maquiladoras provided 60% employment in Ciudad Juarez, Mexico.

Source: ECLAC 2001

The large inflow of external capital during the second half of the 1990s was in response to the extensive privatization processes of Brazil. Approximately 30% of FDI flowing into Brazil during 1999 was directed toward the privatizations of various state owned industries. Though the inflow of capital to the Brazilian economy remained high in 2000, the amount directed toward the privatization process dropped to 12% of total FDI, as represented in table 3. "In 1999 almost 30% of FDI flows (US$ 8.786 billion) were directly linked to different privatization processes (US$ 6.659 billion in the telecommunications industry, US$ 1.106 billion in the electricity industry). In 2000, however, only 12% of total FDI income reported in the first ten months of the year was directed at the purchase of state assets (US$ 2.033 billion in telecommunications, US$ 295 million in gas and US$ 693 million in electricity)" (ECLAC 2001, 43).

The remainder of FDI has been invested in non-privatization investment such as the services sector, manufacturing sector, and the chemical and pharmaceutical industry. Of the many industries receiving FDI, the service sector can account for almost 2/3 of total FDI in 2000 thus, receiving more than traditional sectors of foreign direct investment. Another sector to note is the manufacturing sector. In 1995 it received more than half (55%) of total FDI and in 2000 only received approximately 24%.

Though Brazil has greatly slowed its privatization process during the late 1990s and in 2000 it remained one of the largest recipients of foreign direct investment. In addition as inflows of foreign capital have changed destinations from traditional sectors to new sectors (service, financial and commercial industries) they are future prospects in maintaining and attracting foreign investment.

TABLE 3. Foreign Direct Investment in Brazil, 2000

Source: ECLAC 2001

As shown above with the cases of Mexico and Brazil, the recent surge in FDI flows to Latin America is due to the liberalization of policies governing the free flow of FDI and MNCs activity in regards to the mobility of capital. Another major factor contributing to this surge have been the privatization programs during the 1980s and 1990s. Almost every country within Latin America has undergone liberalization processes governing foreign investment. Major reforms have been made in legistlation governing trade and investment. Though most Latin American countries implemented strict barriers to trade and foreign investment during the 1930s through the 1960s (ISI) limited capital was allowed if it contributed to import substitution. Such sectors that did receive foreign capital during this era were the manufacturing industries.

Restrictive policies governing foreign investment continued throughout the 1960s and 1970s by means of capital controls. When it was realized that the very pillars of such a system was the cause of the region’s economic downturn, marked by inflation and growing external debt, a process of liberalization seeped into the political economy of the Latin American region.

By the 1980s Mexico began the liberalization of foreign investment and trade policies. In the 1990s it pursued regionalization with the adoption of NAFTA in 1994. So that its economy appeared market oriented to foreign creditors. On the other had, Brazil began privatization and liberalization in the mid-1990 until the end of the decade. In addition, these countries have often been recognized as late reformers or slow reformers when compared to their other Latin American counterparts. Chile implemented liberal reforms in the early half of the 1970s and Argentina began liberalization in the latter half of the 1970s. In regards to both of these countries implementing liberal reforms in the 1970s, they have been noted as early reformers within the Latin American region

Mexico experienced a surge in capital flows during the 1990s while Brazil experienced the inflow during the second half of the 1990s. Both countries have remained dominant recipients of foreign direct investment during the year 2000. Though Brazil has significantly slowed its privatization process the inflow of foreign investment has been driven by other factors such as the service sector (Internet and telecommunications). Future prospects for Mexico as a foreign capital recipient are also positive. Mexico is expected to remain one of the largest recipients of foreign direct investment due to the commerce and finance industries.

Referencing Mexico, specific sectors that remain highly protected can deter greater inflows to the region. Sectors such as the communication industries, with the exception of cellular telephony, remain highly protected. The state owned company, TELMEX, if privatized is sure to attract increased volumes of foreign capital as was evident within the Brazilian case of privatization.

Again long term prospects for FDI are positive for Latin America. The trends of the 1990s are expected to continue as long as the region of Latin America continues to support policies that encourage FDI flows. These can include continued FDI liberalization, trade liberalization (by regionalization or bilateral and multilateral agreements), improved government institutions (through transparency), and continued privatization processes.

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