A Critical Analysis of the impact of global financial markets on
developing economies
Abstract:
The impact of global financial markets on developing economies has received intensive
discussion in recent decades. Former researches can be divided into two groups according to their
different application of Mundell-Fleming model, which reveals the “unholy trinity” of capital
mobility, independent monetary policy and stable exchange rate. Some argue that given high
capital mobility, the choice left for developing countries is not to choose two goals among three
options, but rather the trade-off between monetary autonomy and exchange rates stability.
Furthermore, there will be a convergence of world interest rate. Others observe that the three
options in the model are still available, thus it is not necessary to give up monetary autonomy.
Moreover, given the enabling power from fluctuating global financial markets, states will have
incentives to reduce capital flows in order to shelter themselves from external shocks. The author
shares the belief of the latter group. Through comparative case studies between Mexico and Chile
under relatively weak constraining power of capital, and studies between Mexico and Malaysia
under strong constraining power of capital, the article draws a conclusion that political preferences
and institutional capacity still matter in monetary policy-making, thus even the high capital
mobility does not prevent the states from making independent monetary policies.
Key Words: CMH; imperfect capital mobility; monetary autonomy; political preference;
institutional capacity
Ⅰ Introduction
The interactions between market force and state autonomy never fail to attract hot debates in
IPE research area, and the impact of global financial markets on state autonomy since the collapse
of the Bretton Woods System and the reemergence of global finance is among the most popular
topics. Most of the former researches focus on experiences of advanced countries. However, the
fluctuation of financial markets in developing countries and its contagion effects on global
economies have made scholars in advanced countries to turn more attentions to what are
happening in the rest of the world (Mosley, 2003; Strange, 1998).
Although the assumptions, methodologies and opinions largely differ among former scholars,
nearly all of them find that the Mundell-Fleming model is a very useful analyzing tool (Andrews
1994; Oatley 1999:1004-1009; O’Brien and Williams 2002:229). According to this model, state
can only achieve at most two goals among the following three options: high capital mobility,
independent monetary policy and stable exchange rates. Or we can call such situation “unholy
trinity” (Cohen, 1993). Thus, former researches on the impact of global finance on policy
autonomy in developing countries can be divided into two groups, based on their contrasting
opinions on the trade-off among these three options.
Those who insist on the Capital Mobility Hypothesis（CMH） (Bernanke 2005; Cohen
1996:281; Oatley 1999:1004-1009) argue that the choice left for developing countries is not to
choose two goals among three options, but only the trade-off between monetary autonomy and
exchange rates stability. Moreover, given the strong market forces, there will be a convergence of
world interest rate, which means monetary autonomy will be severely limited.
And the others who insist on imperfect capital mobility argue that the three options in the
Mundell-Fleming model are still available. Moreover, given the enabling power of fluctuating
global financial markets, states will have incentives to create room for political maneuver in order
to shelter themselves from external shocks, thus monetary policy will diverge as a consequence.
The author shares the belief of the latter group. Therefore, the main purpose of this article is
to point out that the constraining power of capital on state autonomy is lower than has estimated
by mainstream researches for two reasons: 1, capital mobility is not perfect due to the nature of
global financial markets and the efforts of states to slow down capital flows; 2, when “push”
factors dominate capital inflow, constraining power is relatively low even capital mobility is quite
high.
This article is divided into six sectors. Sector I is the introduction. Sector II makes a
retrospect of the re-emergence of global financial markets and the shift of financial policies in
developing economies. Sector III will introduce the arguments that the monetary autonomy in
developing economies is undermined and a neoliberal policy convergence is inevitable. Sector IV
will refute those arguments with imperfect capital mobility. Sector V makes comparative case
studies between Mexico and Chile, and the case studies between Mexico and Malaysia to support
section IV. Sector VI is the conclusion.
Ⅱ The re-emergence of global financial markets and the shift of financial
policies in developing economies
The re-emergence of global financial markets is shaping a new world economic order that
differs from the one under the Bretton Woods System (Helleiner 1994). Emerging in the
Eurodollar markets in 1960s and coming into being since the collapse of the Bretton Woods
System in 1970s, global financial markets have the following characteristics:
Firstly, they are built on a floating exchange rate regime among developed countries, which
is different from the pegged exchange rate regime in the three decades after WWII;
Secondly, they are built on a paper dollar standard (Strange 1994:107-10; Aliber 2002)
instead of the former gold-dollar standard, so the supply of the world key money and reserve
money is not constrained by the gold reserve of the US Treasury;
Thirdly, the size of global financial markets is increasing dramatically. For instance, by 1995,
the largest international clearing system CHIPS cleared transactions worth $1.3 trillion via
computer systems a day (Strange 1998a:24); from 1986 to 1996, the world’s main bond issues
tripled, securities issues increased more than tenfold and foreign exchange transactions quadrupled
to $1 trillion (Erdman 1996, quoted in Strange 1998a:17-18); by 1998 institutional investors are
estimated by IMF to hold $20 trillion assets (Mosley 2003:106);
Fourthly, global financial markets are far from being well regulated and are opt to financial
crises, contagions, defaults, arbitrages and speculative attacks (Strange 1998a; Eichengreen 2003),
and the fluctuation of financial markets have led to the disappointing slow down of world
economic growth rate (Krugman 2000).
Contrary to the poor ability of developing economies to create credit (Strange 1994:103-4;
Mosley 2003:34-38; Lairson and Skidmore 2003:377), the global financial markets have the
strong ability of credit creation (Strange 1994:90), which brings both opportunities and risks to
developing economies.
On the one hand, global financial markets provide developing economies easier access to
plenty of capitals. From 1984 to 1993, private financing in developing countries rose from $35.6
billion to $159.2 billion in 1993, which increased 300% comparing to the 61% in official
development financing (Haley 1999:74-5). Nowadays emerging markets are issuing bonds or
equities rather than borrowing bank loans, and institutional investors are holding 90% of the
portfolio assets invested in developing nations (Mosley 2003:106).
On the other hand, due to their small share in global financial markets, developing economies
are quite vulnerable to external fluctuations. The huge sum of financial assets hold by institutional
investors means that even a small change in the portion of portfolio assets will lead to large capital
inflows or outflows in developing economies (Mosley 2003:106). Moreover, when the investment
climate shifts from a mania to a panic, the consequent disasters such as financial crises, contagion,
huge sovereign debts and economic recession will happen (Strange 1998a:97-121).
As a result, dozens of heavily indebted countries have experienced a “lost decade” from
1970s to 1980s, and many developing countries were poorer in 1990 than in 1980. Furthermore,
debt burdens of developing economies are still deteriorating because the percentage of central
government expenditure on debt service exceeded that on basic social services over the 1980s and
1990s(Strange 1994:113; O’brien and Williams 2002:239). Developing country debt had exceeded
$2 trillion by 1997, a huge burden comparing with the $200.7 billion annual net private capital
flow to developing countries in 1996 (Singh and Weisse 1998:608).
Paradoxically, the “lost decade” in Latin America was accompanied with the “triumph” of
neoclassical economics and policy convergence (Biersteker 1992). Although Biersteker predicted
in 1992 that convergence towards a neoliberal economic policy would not be sustainable without
economic growth under neoliberal reform, Latin American countries deepened their deregulation,
privatization and financial liberalization after the 1994 Mexico financial crisis (Grabel 2000:4-5).
Moreover, when 1997 Asian financial crisis was unfolding, Latin American and Asian economies
like Brazil, Argentina, Hong Kong and Singapore adopted neoliberal policies to assure foreign
investors (Grabel 2000:4-5).
Ⅲ The Capital Mobility Hypothesis and its constraining power on developing
economies
How to explain and predict the monetary policy choices of developing economies in global
financial markets? Believing in the CMH (Bernanke 2005; Cohen 1996:281; Oatley
1999:1004-1009), many scholars argue that the choice left for developing countries is only the
trade-off between monetary autonomy and exchange rates stability.
The firmest representative of this group is David Andrews (1994). He argues that capital
mobility fits the strictest criteria of the structure power in IR theory, which will lead to the
identical actions among states in general. The CMH raised by Andrew consists of two
determinants.
Firstly, the development of telecommunication and information technologies has reinforced
the ability of capital to evade from states regulations and made the attempts of capital controls
costly and even fruitless.
Secondly, market forces have driven states to adopt identical policies of financial
liberalization that has led to the integration of global financial markets. Capital mobility and
financial liberalization reinforce to each other, but the technologic side of determinants means that
capital mobility is also independent on state regulations, thus even the reverse of financial
liberalization is not enough to shelter states from the constraining power of mobile capital.
Andrews furthered his arguments that, based on the logic of Mundell-Fleming model and given
the CMH, the choices left for states become the trade-off between monetary independence and
stability of exchange rate. Moreover, just as Efficient Market Hypothesis has predicted the
convergence of commodity price in full competition markets, given the combination of perfect
capital mobility and highly integrated global financial markets, the optimal policy choice of
interest rate will be the convergence of interest rate—the “price” of capital—between countries,
because any interest rate policy diverges from regional and global trends will be punished by the
exit of capital, exhaustion of foreign reserves or unexpected forces on exchange rate change.
Many research findings echo with Andrew's CMH that the “structure power” of capital
mobility has severely constrained state autonomy in developing countries. (Armijo 2001:34;
Friedman 2000; Gill and Law 1989; Ohmae 1995:12; Rodrik 2001; Strange 1993). Moreover,
comparing with the "strong and narrow" constraining effects in developed countries, the
constraining effects in developing countries is “strong and broad” (Mosley 2003:34-9,116), state
authority should not only pay attention to macroeconomic indicators such as inflation rate, deficit
and the ratio of foreign debt/GDP, but also deal with microeconomic policies such as tax policies,
public expenditures and social security programs very carefully in order not to evoke negative
responses of global financial markets (Mosley 2003:34-9,116).
After the publication of Andrew’s work, the independent characteristic of capital mobility
and the reinforcement effects between capital autonomy and liberalization of financial regulations
have been repeatedly reported.
Firstly, high technology and plenty of information reduce transaction costs and increase the
price sensitivity of financial markets across borders, thus confers great constraining power on
global financial markets, which makes capital-thirsty developing economies particularly
vulnerable to external influences (Cerny 1994; Friedman 2000:112-7; Strange 1994:91);
Secondly, a neoliberal reform is not only desired by international investors but also enforced
by international financial organizations and the world dominant country—the United States,
because a neoliberal reform is seemed to decrease the possibility of default of sovereign debts
(Mosley 2003) and increase the “policy credibility” of developing economies (Grabel 2000:1-5);
Thirdly, the integration to global financial markets have changed the preferences of domestic
institutions, firms and investors, those “invested interests” (Frieden 1991) are lobbying for an
open global economy. In the meantime, political actors within “the competition states ” are also
seeking allies with these invested interests in order to gain political supports (Cerny and Evans
2004), thus, convergence toward a neoliberal economic policy is both “pushed” from outside and
“pulled” from inside;
Fourthly, international and domestic investors have shown their capacities to influence
economic policies because those nations which do not follow the neoliberal economic policies
have been punished by capital withdraw and capital flight (Mahon 1996), and those which put on
“the golden straitjacket”(Friedman 2000:104-111) have been rewarded by capital inflows (Grabel
2000:4-5);
Finally, due to the rational expectation of government policy-makers, it’s the “mobility”
mentioned above, not necessarily the “movement” of financial capitals constrains policy
autonomy (Thomas 2001:113; Sinclair 2001:95).
As a result, when developing economies try to maintain some monetary autonomy through
capital control, such attempts have proved to be very costly because of the heavy interest burden
of keeping a large sum of foreign reserves through foreign borrowing and the potential speculative
attacks on exchange rates (Bernanke 2005). Capital control is likely to be fruitless because of the
advanced technology and the prevailing corruption in developing economies that make it very
easy for capital to evade state regulation (Bernanke 2005, Edwards 1999). Although liberal
institutionalists show more sympathy than neoliberalists to anti-cyclic financial regulations in
developing economies, they believe that it is impossible to achieve without supranational financial
regulations (Cohen 1998,2003a,2003b; Eichengreen 2003; Rodrik 2001; Schmukler 2004;).
To sum up, the scholars convinced of CMH believe that the monetary sovereign of
developing economies is inevitably undermined, and monetary authorities are either conferred on
private authorities or on supranational institutions.
Ⅳ The constraining power on developing countries under imperfect capital
mobility
Although the arguments of CMH are theoretically convincing and have been proved by many
observations on policy-making, CMH still suffers from the limited explanatory power at the real
world in general. Under perfect capital mobility, the risk-adjusted domestic interest rate must
equal the world interest rate (Oatley 1999:1004). However, when short-term markets demonstrated
a high degree of integration during 1980s (IMF 1991 and Marston 1995, quoted in Oatley
1999:1004), it has been found that there is still large divergence in the real interest rates around
the world (Frankel 1992, 201;Watson 1999,63). Using a sample of over 100 developing and
industrial countries from 1973 to 2000, (Shambaugh, 2004) demonstrates that countries with
flexible exchange rates have more autonomy to set their own interest rates rather than simply
follow the interest rates in the base countries. Furthermore, since the interest rates in the US, EU
and Japan—three base countries of world’s main currencies—remain diverse, monetary authority
in developing economies under fixed exchange rate regime can achieve limited autonomy in
setting interest rates by changing the base country or the composition of a currency basket
(Shambaugh, 2004).
If capital mobility is perfect, and global financial markets are highly integrated, why there is
no convergence of the “price” of capital? The divergence of real interest rates in developing
countries from developed countries sends an important signal: developing countries still have a
certain degree of monetary autonomy, albeit the needs of high economic costs and political
capacity to achieve it in global financial markets. The CMH fails to explain the real world because
it both overlooks the political capacity of nation-state to maintain state autonomy and overstate the
mobility of capital.
Believing in imperfect capital mobility, many scholars argue that the three options in the
Mundell-Fleming model are still available, thus it’s not necessary to give up monetary autonomy.
Furthermore, in order to shelter themselves from external shocks, states will be given the enabling
power from the fluctuating global financial markets.
State autonomy under imperfect capital mobility
Many researches on developing countries have found that the imperfectness of capital
mobility is independent on state regulations; moreover, state autonomy and imperfect capital
mobility reinforce each other.
Imperfect capital mobility gives incentives for state autonomy, because under imperfect
capital mobility the constraining power of capital is relatively weak. Imperfect capital mobility is
caused by three factors: home bias, host country bias, and segmentation of financial markets. In
other words, imperfect capital mobility can be caused by state intervention, but it is also
independent on state intervention. In cases of home bias and host country bias, imperfect capital
mobility is caused by factors deeply rooted in financial markets themselves.
Home bias means that residents tend to invest domestically rather than invest abroad. It is
reported that 90% domestic investment worldwide is financed by domestic capital (Wade 1996,
quoted in Lukauskas 1999). The percentage is roughly the same in developing countries
(Jaspersen, Aylward and Sumlinski 1995, quoted in Lukauskas 1999), while more than 90 percent
of American and Japanese equity wealth is held at home (Tesar and Warner 1998).
Host country bias means that when investors invest abroad, their choices are actually limited.
The top 20 countries in emerging markets absorb 90% of the investments to emerging markets as a
whole (Mosley 2003).
Segmentation of financial markets comes from state intervention. States can prevent global
financial markets from further integration through capital control (Lukauskas and Minushkin 2000,
Schamis and Way 2003), sterilization (Spiegel 1995, Willett, Keil and Ahn 2002) and change of
exchange rate regimes (Shambaugh 2004). At that time, financial markets opening are limited in
breadth and depth through capital controls, or because capital flows are delayed through
sterilization, or the intermediation of the constraining power of capital mobility is changed
through the change of exchange rate regimes. As a result, capital mobility will be reduced.
In next section, using the comparative studies between Mexico (before 1994 peso crisis in
1990s) and Chile (1990-1998), I will give more details of how independent monetary policy is
achieved under relatively weak constraining power of capital mobility, and its economic and
political motives and consequences as well.
State autonomy under high capital mobility
Even high capital mobility has enabling power on state autonomy because of the fluctuation
nature of global financial markets. Two factors of global financial markets cause the fluctuation:
one is business cycle in OECD countries, and the other is herd behavior of international investors.
Domestic factors such as moral hazard, corruption and inefficiency of public finance may also
contribute to financial market fluctuation, but many scholars agree that external factors deeply
rooted in financial markets are the dominant determinations.
Many researches have found that business cycle in OECD countries determine the timing of
capital inflows of developing countries (Calvo and Reinhart 1995; Eichengreen and Fishlow 1995;
Haley 1999:76-8; Tesar and Werner 1995). When world interest rate is low, capital in OECD
countries flow out of less-risk OECD countries looking for higher return in developing countries.
Haley (1999) finds that in time of capital inflow, “push” forces from world interest rate is
dominant rather than “pull” forces from domestic fundamental factors, the constraining power of
mobile capital is relative weak despite high capital mobility. That is to say, whether the
constraining power of capital mobility is strong or weak, is not determined by how high is the
mobility, but rather determined by whether the “push” forces or the “pull” forces are dominant.
The balance between supply and demand always matters.
On the contrary, when world interest rate is high, for instance, when the US raises its interest
rate, capital will flow out of developing countries, thus the constraining power on policy
autonomy will be quite strong. In absence of capital control, states must follow the world trend
and raise their interest rates, no matter what damages it will do to domestic economy. Any
attempts to keep monetary autonomy will be punished by capital flight. However, states can also
adopt measures of capital control in order to maintain monetary autonomy, albeit at their own risk
of scaring away future international investors (see later case study of Malaysia).
Herd behavior of international investors can also enforce capital mobility. There are two
kinds of mechanism in global financial markets that create herd behavior: one is concentration of
decision (Mosley 2003), the other is the pricing mechanism of capital (Erturk, 2005).
Firstly, as Mosley points out, although the development of telecommunication and
information may help to solve the problem of information asymmetry between states and private
investors as a whole, it does not lead to the diffusion of decision. Because the costs of collecting
and analyzing information are high, investors prefer following the behaviors of big investment
institutions to making anti-cyclic decisions.
Secondly, Erturk argues that the pricing criteria of capital are not always objective. There are
many cases that what other people think of the value of financial assets determine their prices.
Thus it is very probable that investors will continue to buy financial assets when their prices are
neither sustainable nor supported by domestic economic conditions. As a result, when capital
flows in developing countries are dominated by herd behavior, a boom-bust cycle becomes
inevitable. Again the monetary autonomy is reinforced in time of capital inflow and severely
constrained in capital outflow.
In sum, when capital flows is dominated by external factors such as business cycle in OECD
countries or herd behavior of international investors, investors care less about the fundamental
factors in developing countries. On the one hand, states gain more autonomy in time of capital
inflow; one the other hand, state autonomy is constrained in time of capital outflow. However, if
damages which pro-cyclic monetary policy will do to domestic economy is intolerable, fluctuation
of financial markets will have enabling powers on state autonomy, which means states must adopt
measures of financial market segmentation in order to cushion the external shocks.
In next section, using the comparative studies between Mexico (shortly before and after 1994
peso crises) and Malaysia (in 1997 Asian financial crises), I will give more details of how state
autonomy is achieved under relatively strong constraining power of high capital mobility, and the
economic and political consequences of monetary independence as well.
Ⅴ Comparative case studies of state autonomy
This sector consists of two parts: comparative studies between Mexico (before 1994 Peso
crises in 1990s) and Chile (1990-1998); comparative studies between Mexico (from 1994 to 1997)
and Malaysia (after 1997 Asian financial crises). In former cases, the constraining power of global
capital mobility is relatively weak for these two Latin American countries, and in latter cases the
constraining power is strong.
State autonomy under relative weak constraining power
The constraining power of global capital mobility was relatively weak for Mexico from 1990
to early 1994 because the “push” forces dominated capital inflow during that period due to the low
interest rate in the US. Nevertheless, since Mexico adopted a strictly fixed exchange regime at that
time (Sales-Sarrapy 2000:257), according to the CMH, the Mexican government should have been
constrained from any attempt of carrying out independent monetary policy. But the reality was
that the Mexican government made attempts to maintain its independent interest rate for political
reasons (Kessler 1998:36-66). From 1990 to 1994, under the shadow of a narrowly-won election
in the end of 1980s, the Mexican government was carrying out a large program aiming at
compensating the poor and others who were harmed by liberal reforms. The program was financed
by the income of selling national-owned financial institutions to private investors. In order to
make the transaction more attractive to potential future new bankers, those newly established
private banks enjoyed quite high autonomy against severe international market competitions, and
a high interest rate was among those autonomies. Sterilization was adopted as a necessary method
to cushion the forces on appreciation. Unfortunately, Mexico was running out of foreign reserves
before 1994 Peso crises, which among other factors contributed to the crises (Maxfield
1998:1211-2).
Contrast with the crisis-prone characteristic of monetary policy of Mexico from the end of
1980 to early 1994, independent monetary policy helped Chile focus on domestic economic
growth from 1990 to 1998 (Larrain B. and Laban M.2000:223-250). The constraining power was
relatively weak for Chile during that period because its currency continued to be under
appreciation forces before the 1997 Asian financial crises. Confronting the appreciation pressure
brought by large sum of capital inflows in early 1990s, Chilean government preferred shifts of
exchange rate regimes, segmentation of financial markets and liberalization of capital outflows to
giving up monetary autonomy. The policy of independently setting interest rates was very
important for Chile because of both economic and political reasons. On the one side, low interest
rates coherent with global trend were beneficial for export sectors; on the other side, relatively
high interest rates was needed to fight inflation. Nevertheless, the belief that the world low interest
rates was not sustainable due to the political cycle in the US dominated the considerations of
monetary policy- making, so that the Chilean government decided to maintain their independent
interest rate at the expense of shifts of exchange rate regime. Measures of sterilization and capital
control were adopted, which helped to shelter Chile from the shocks of the 1994 Peso crises and
the 1997 Asian financial crises. For instance, during the 9 months since the end of 1997, the
nominal exchange rate only depreciated over 7 percent.
Both Mexico and Chile tried to maintain independent monetary policy with global capital
mobility, which is contrasting with the constraining effects predicted by many scholars. Political
preferences still matter, which is the first lesson we can learn from their experiences. In the case of
Mexico, an independent high interest rate made buying former national banks looked profitable,
thus the government could continue to use the incomes of selling banks to finance its social
compensating program, which would help the ruling party to win votes in next election. In the
case of Chile, an independent high interest rate was beneficial for fighting inflation. Moreover,
given the existence of capital mobility, political preferences is not less important than institutional
capacity in achieving monetary autonomy. Exchange rates must be stabilized, segmentation of
financial markets must be carried out, while future return to international investors must be
assured. Those seemingly goals are quite challenging for developing countries because those who
fail to make a correct trade-off will face policy failure and even financial crises, just as we have
seen in the case of Mexico.
Then, what accounts for different institutional capacities between Mexico and Chile? I have
two answers. Firstly, international payments balance matters. For instance, Chile didn’t suffer
from the large trade deficit as Mexico. In other words, good economic conditions will give states
more bargaining power against international investors. Secondly, the base countries of exchange
rates matter. Chile had tried to change the peg of the central rate to a basket of currencies of the
dollar, the deustsche mark, and the yen, which reflected its tight trade links with Asia (Larrain B.
and Laban M.2000:241). Although Larrain B and Laban M. argued that a basket of currencies was
insufficient to offset the appreciation forces, at least it had sheltered Chile better from speculation
and the fluctuation of the US interest rates.
State autonomy under strong constraining power
The constraining power of capital mobility for Mexico was quite strong from 1994 to 1997
since the US Federal Reserve began to raise interest rates in early 1994 and Mexican’s economic
credit was suffered from the 1994 Peso crises. Although high capital mobility didn’t refrain the
Mexican government from a short-lived attempt of maintaining independent interest rates in early
1994 (Maxfield 1998:1211-2), state autonomy was severely constrained during that period
(Sales-Sarrapy 2000:261-263).
At the beginning of a series of the US interest rates raises in early 1994, the Mexican
government should have immediately raised its interest rates in response. However, the
consideration of monetary policy at that time was still dominated by political reasons because
1994 is the election year. In order not to deteriorate the situation of domestic banks with great
non-performance loans and not to turn those heavily borrowed middle-class into heavily in-debt,
the Mexican government tried to maintain former interest rates in hoping that international
investors would be assured by improved economic conditions. When depreciation forces grew,
Peso was not devalued immediately due to similar political considerations. Those factors
combined with growing trade deficit contributed to the following Peso crises.
On the contrary, Mexican government largely gave up its independent monetary policy after
the Peso crises. Interest rates were raised and monetary supply was tightened, actually domestic
credit during 1995 decreased by 78 billion pesos. Fiscal adjustment was carried out as well, total
public expenditure in 1995 was reduced by 4.9 percent in real terms comparing to 1994.
Comparing with the failure of Mexican government to maintain independent monetary policy
under high capital mobility, the Malaysian’s experience after 1997 Asian financial crises was a big
success (Doraisami 2004). A Keynesian recovery was achieved thanks to expansionary monetary
policy and stable exchange rates. Under strong constraining power after crises, the low interest
rates and stable pegged exchange rates would have been impossible without those measures of
capital control which were adopted 14 months after the crises were unfolding. Offshore financial
institutions were closed, while capital flows of FDI were still free, the selective nature of capital
control, combined with good economic behavior of Malaysia, helped to prevent Malaysia from
panic of capital flight and a sharp depreciation of ringgit. Breaking the "Impossibility Trilemma or
Trilogy", Malaysia enjoyed monetary autonomy under a fixed exchange rata regime (Rajan
2002:149-150).
Both Mexico (in early 1994) and Malaysia tried to maintain independent monetary policy
even under strong constraining power of high capital mobility, which is severely contrasting with
the result predicted by many scholars. Here again, firstly, political preferences still matter. In the
case of Mexico, an independent low interest rate was hoped to help maintain achievements of
former banking reforms, while its Malaysian counterpart was hoped to help gain a Keynesian
recovery from financial crises. Secondly, different institutional capacities between Mexico and
Malaysia led to different outcomes. Mexico failed to defend its fixed exchange rate, thus lost its
monetary autonomy in the aftermath of financial crises. On the contrary, Malaysian ringgit was
stable under capital control, thus a low interest rate was maintained. Both domestic and
international economic factors caused these differences of institutional capacities. Thanks to high
domestic saving rate, Malaysia didn’t rely so heavily on foreign borrowing as Mexico. Moreover,
the top two trades partner of Malaysia are the US and Japan, while most of international trade
transaction in Mexico is only made with the US, which make Mexico more vulnerable to the
fluctuation of the US economy.
Ⅵ Conclusion
What can we learn from the two case studies combined? Firstly, we do not find a
convergence of monetary policy, whether the constraining power of capital mobility is relatively
weak or strong, which contrasts with the prediction of many scholars. Secondly, political
preferences still matter in the decision-making of independent monetary policy, both in democracy
country like Mexico under pressure of election and authoritarian country like Malaysia whose
legitimacy was built on economic development. Thirdly, institutional capacity is the dominant
determinant of the success of an independent monetary policy. Fourthly, both domestic economic
behavior and the composition of international economic partners contribute to institutional
capacity. In the case of Mexico, since Peso is only linked to the US dollar and most trade
transactions are made with the US (Jamson 2002:133), the room for political maneuver is severely
limited, albeit it doesn’t prevent Mexican government from adopting some short-lived
independent monetary policies.
Our findings are consistence with those arguments that the three options in the
Mundell-Fleming model are still available, so it’s not necessary to give up monetary autonomy in
the trade-off among capital mobility, monetary independence and exchange rate stability.
Moreover, given the enabling power of fluctuating global financial markets, states will have
incentives to create room for political maneuver in order to shelter themselves from external
shocks.
Thus, we can draw a conclusion that the constraining power of capital mobility does not
prevent the states from making independent monetary policies. However, the existence of capital
mobility has made the trade-off among capital mobility, monetary independence and exchange rate
stability quite challenging for developing economies. As a result, those who lack of institutional
capacity will surrender to capital mobility and will lose its independent monetary policies.
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Author: Lu Min(陆敏)，Warwick University , Master of IPEA
Address: 32 Eastcotes, Coventry, UK, CV4 9AU
Email: min.lu@warwick.ac.uk
作者：朱喆， 复旦大学经济系宏观经济学专业博士，1976 年生，浙江杭州人
联系方式： 021-54772248， 13012857949，zhuzhe1976@sina.com
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