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Federal • e erve


of St.
Federal Reserve Bank of St. Louis






~ ~


before the

Chicago, Illinois
October 14, 1994

I am honored to be here today to address the 2nd Pan
American Congress organized under the auspices of Forex

This group brings together foreign exchange traders

and experts in international finance throughout the Western

The dialogue provided by gatherings such as

these, both formal and informal, improves our collective
understanding of developments in each other's markets.


times of stress, the contacts we develop on these occasions
can serve us well, helping us--policymakers and
practitioners alike--to do our jobs that much better simply
because our understanding of each other is that much
As most of you know, we at the Federal Reserve Bank
of New York have a dual role vis-a-vis the foreign exchange

For one, we participate in this market in our

capacity as the operating arm of the Federal Reserve system
and the U.S. Treasury.

Second, as the central bank, we

have an interest in · promoting the smooth functioning of the

In both our roles, we are very supportive of

Forex's current efforts to promote educational programs
among its members.

We believe that such efforts will

further enhance the efficiency and integrity of what
remains the largest unregulated market in the world.
In my remarks this afternoon, I would like to share
with you some of my views on the changing nature of the
Federal Reserve Bank of St. Louis


increasingly important trade and financial linkages that
characterize relations among our countries in the Western
Hemisphere today.

In so doing, I will touch on such issues

as the importance of Western Hemisphere markets for the
well-being of our countries' economic and financial policy
interests, the impact of NAFTA to date, and the increased
financial flows that bind all of our countries in the
region and raise the stakes each of us has in the economic
success of our neighbors.
Trade linkages are clearly one of the most obvious
ways our economies in the Western Hemisphere are bound

These linkages are critical to the ability of

each of our countries to reap the benefits of our
comparative advantages and thereby realize our growth
Over the past several years, trade ties among our
countries have strengthened significantly, beginning with
the historic agreement between the United States and Canada
to create a free trade zone in 1989.

This agreement has

benefitted both our countries by sharply lowering tariff
and nontariff barriers and improving our ability to resolve
trade differences.

Today, Canada and the United States

enjoy the biggest trading relationship of any two countries
in the world, with two-way trade amounting to about
$200 billion in 1993.
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While the free trade agreement


between the United States and Canada cannot ensure that we
will always see eye-to-eye on all issues--differences of
view are, after all, to be expected in relations between
sovereign nations--it does mean that our two governments
are committed to finding compromise solutions to whatever
differences we may have.
In a second historic trade development, Mexico
joined the United States and Canada last year in signing
the North American Free Trade Agreement.


implementation of NAFTA at the beginning of 1994 heralds a
new process of broader and deeper trade linkages among
countries in the Western Hemisphere.

Among its other

achievements, NAFTA sets the stage for potentially
significant gains in trade--and finance--for its three

In addition, NAFTA signals the U.S.

commitment to free trade for the hemisphere.
Although only 10-months old, NAFTA has already begun
to make its mark.

In the six months through June, U.S.

exports to Mexico have risen roughly 17 percent over the
comparable period in 1993, to almost $25 billion.
too, is benefitting from NAFTA.


For Mexico, NAFTA locks in

trade liberalization and further opens the economy to trade
and foreign investment.

In 1994, Mexico's exports to the

United States through June were up 22 percent over the
comparable period in 1993.
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In fact, Mexico has recently


overtaken Japan as the United States' second-ranking
trading partner.
At the same time as it has been deepening its trade
ties with its North American neighbors, the United States
has also sought to develop its trading relations elsewhere
in the hemisphere.

As countries throughout Latin America

and the Caribbean have increasingly liberalized their trade
regimes--lowering tariffs to an average of 12 percent from
roughly 56 percent a decade ago--u.s. exports to the region
have almost doubled in the past seven years.


17 percent of U.S. exports now go to this region compared
with about 12 percent in the 1970s.
One of the most notable developments over the past
several years, reflecting the more outward-looking trade
policies that have taken hold throughout the Western
Hemisphere, has been the growing rediscovery of
intraregional markets.

Today, as never before,

multilateral and bilateral trade agreements are being
forged throughout Latin America and the Caribbean.
Colombia, Venezuela, and Mexico have just recently signed
such an agreement.

Mexico has a free trade agreement with

Chile and is in the process of negotiating a similar
agreement with some of its neighbors in Central America.
And, the Andean pact countries--encompassing Venezuela,
Colombia, Ecuador, Peru, and Bolivia--agreed a few months
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ago to a common external tariff--25 years after their
initial agreement was first signed.

Moreover, existing

arrangements, such as the Caribbean Community (CARICOM) and
the Central American Common Market, are becoming
increasingly outward-looking through reductions in tariff
rates with the rest of the world.
By increasingly breaking down barriers to trade,
these multilateral and bilateral agreements are helping
countries in the region become more competitive.

They also

reflect the willingness of these countries to turn away
from their protectionist policies of earlier decades.


addition, the agreements are evidence of these countries'
longer term commitments to stable trading conditions within
the hemisphere, giving confidence to domestic and foreign
investors alike.
As a result of these developments, intraregional
trade, which had fallen off dramatically in the years
following the onset of the debt crisis in the early 1980s,
is thriving.

For example, trade among Latin America's

eleven largest economies has increased by some 50 percent
since 1991.

These increases in intraregional trade helped

make possible last year's relatively rapid growth of
overall external trade in Latin America in a period when
world trade was decidedly sluggish.
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Among the most important of the new regional trade
groups is the Southern Cone Common Market--Mercosur--which
Brazil, Argentina, Uruguay, and Paraguay created in 1991 as
a free trade zone.

Since signing this agreement, these

countries have seen their mutual trade more than double.
Just recently, the Mercosur countries further agreed to
deepen their trade relations by forming a customs union by
January 1, 1995.

In so doing, they will establish a common

external tariff for their imports from third countries,
obviating the need for them to agree on rules of ori~in for
imports, which are complicated to negotiate and often
potential obstacles to trade.

The Mercosur agreement also

allows for the future accession of other countries.
Notwithstanding the recent progress of trade
integration within the Western Hemisphere, the potential
for further and constructive deepening of mutual trading
relationships remains substantial.

It is conceivable that,

over the longer term, Latin America will gradually develop
several large trading blocs and that these blocs will be
way-stations to a comprehensive South American Free Trade
Agreement and an eventual amalgamation with NAFTA.


optimism may be premature at this time, the vision is not
totally out of the question either.
It is important, however, that, in the process of
creating regional trade groups, barriers to outsiders not
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be unduly restrictive.

Otherwise, trade diversion could

outweigh trade creation, efficiency deteriorate, and
hemispheric export performance falter.

In short, the

overriding aim of all these regional trade agreements
should be to ensure not only that they do not raise
obstacles to hemispheric integration by pushing other
potential partners away, but also that they remain outwardlooking and consistent with Latin America's need to
integrate more efficiently with the world economy.
On balance, I believe that trade liberalization has
been a major factor leading to the revival of growth
throughout Latin America and the Caribbean.

With the

easing of policies that produced high labor costs and
export taxes, combined with financial reforms that have
facilitated access to credit, Latin American exporters have
become increasingly competitive.

In a number of countries,

there has already been a significant shift away from a
traditional dependence on raw materials and energy exports
toward increases in exports of manufactured goods.


has certainly been the case in Mexico.
To the extent that this new reform orientation in
trade takes root and expands to encompass even broader
groups of countries, we can be more confident that these
regional trade initiatives will work constructively to
harness comparative advantages, exploit economies of scale,
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and thereby boost economic efficiency, competition, and
overall economic performance throughout the hemisphere.


this context, I am convinced that prompt passage of the
Uruguay Round agreement is critical to the goal of global
free trade and to the support of individual countries' own
efforts to build truly open economies that can compete in
world markets.
While trade linkages among our economies provide the
basic underpinnings to our economic relations, the
financial flows that accompany these trade linkages are
also increasingly important.

By channeling savings in the

hemisphere to the areas of highest returns, financial flows
allow the efficiency gains of comparative advantage to be

The growth in the financial linkages among our

economies over the past several years also serves to
improve the functioning of domestic financial systems, and,
by this means, to contribute to the more efficient
allocation of capital among our countries.

Here, too,

changes over the past several years have been dramatic.
As you well know, private capital has once again
begun to flow to Latin America, after a decade of negative
net transfers.

These inflows, on a gross basis, reached a

record $65 billion last year, equivalent to 5 percent of
the region's GDP.

The bulk of these inflows went to the

private sector, unlike the
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in the 1970s.



of this magnitude would have been inconceivable five years
Initially, beginning in 1989, the capital flowing
into Latin America was primarily the return of flight

Today, much of the money going into the region is

in fixed-income securities, typically debt of Latin
American governments and enterprises that is raised on
foreign or international capital markets.

This debt, which

is primarily of short- to medium-term maturities, tends to
be denominated in U.S. dollars.
Most equity investment going into Latin America
results from direct purcbases in local stock markets.
Relatively fewer equity inflows have stemmed from Latin
American firms' issuing equity on international markets,
although purchases of shares in country funds and the use
of American Depository Receipts (ADRs) on the New York
Stock Exchange are quite common.

Telefonos de Chile was

the first Latin American firm to make use of ADRs in July
over the past few years, there has also been a
marked increase in the amount of foreign direct investment
going to Latin America.

According to some estimates,

recent inflows have accounted for almost a quarter of total
funds flowing into the region.

Guided more by the longer

term profitability of domestic enterprises than portfolio
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-10investment, foreign direct investment also provides host
countries with increased access to foreign markets and new
In addition, banks have resumed lending to Latin
America in recent years, typically providing short-term
credits for trade finance and working capital to private
sector borrowers.

There was also some increase in medium-

and long-term lending beginning in 1993.
As private capital inflows to Latin America have
expanded during the 1990s, the investor base has broadened
to include institutional investors, such as pension funds,
mutual funds, and insurance companies, in addition to
securities traders and citizens living abroad.


widening of the investor base has been facilitated by
changes in allowable investments in a number of industrial

The growing diversity in investor base may help

to lower the risk of a sudden and simultaneous drying up of
funds for the region, such as took place during the 1980s.
What all of these capital inflows reflect, of
course, is increased confidence on the part of foreign
investors in the willingness of countries in the region to
adopt comprehensive stabilization and structural reform
programs as well as optimism about the potential for growth
stemming from these efforts.

In most cases, reform

programs have been grounded in commitments by governments
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to extend significantly the role of market forces in the
allocation of resources.

As a consequence, measures

adopted to reduce government budget deficits, control
inflation, eliminate price controls, reduce subsidies,
privatize state-owned enterprises and deregulate and
broaden the financial sector have opened up opportunities
for new investment with potential rates of return
sufficiently high to attract foreign investors.


investors have also been attracted to the region by the
progress so many countries have made toward normalizing
relations with their external creditors, which has reduced
concerns about external debt burdens.
In addition, investor confidence in the region has
been boosted by a host of other structural reforms.
Restrictions on the ability of foreigners to acquire assets
have been eased at the same time as taxes and transactions
costs have been reduced.

Moreover, gains have been made in

upgrading not only the quality of market oversight and
regulation but also the technological capabilities of
markets, such as automating stock exchanges.


systems in clearing and settling financial transactions
have also been introduced, as have measures to decontrol
interest rates, reduce directed credit programs, and
stimulate competition among financial institutions.
Federal Reserve Bank of St. Louis


There can be no doubt that the recent surge of
capital into Latin America has also been facilitated by the
increased technological capabilities of our global
financial markets to mobilize private capital, direct it to
attractive markets, and monitor its exposure to risk.


improvements in communications technology together with the
rapid evolution of computer and data-management technology
have transformed the nature of our financial markets and
institutions and dramatically altered the ways in which
business is conducted, making it possible to execute and
manage an investment strategy on a global real-time basis.
A number of other supporting reasons also helped
generate capital flows to Latin America after 1989.


the most important of these were the high returns available
in Latin American markets relative to those in most
industrial countries.

This was particularly so after the

decline in U.S. long-term interest rates in early 1993.
The impact of capital inflows on the domestic
economies ~f these countries has been profound.

on the

positive side, the inflows have contributed to increasing
domestic investment and offsetting comparatively low saving

Moreover, private capital inflows have also

facilitated the privatization of public enterprises and
contributed in the process to the development of domestic
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capital markets, helping local firms mobilize capital at
lower costs.
At the same time, however, it is important to
acknowledge that these inflows do entail risks and may
raise policy dilemmas for some countries.

Without being

exhaustive, let me suggest a few potential difficulties.
A main risk, of course, is that the inflows may be
not only unsustainable but also subject to sudden changes
in market sentiment.

A lapse in policy, a domestic event

that suggests social or political unrest, or an external
shock such as a change in global interest rates all provide
grist for global investors to reassess their risk exposures
and alter their investment decisions.

To the extent that

portfolio flows are motivated by investors acting on
economic fundamentals in the host country--characterized by
that country's pursuit of consistent macroeconomic policy-the inflows should be more sustainable than if they are
motivated by investors seeking to take advantage of
temporary profit opportunities arising from the
implementation of less consistent macroeconomic policies.
The sharp declines in both share prices and bond
financing in early 1994 throughout Latin America, following
the increase in U.S. interest rates in February, are a
reminder that many of these markets can be more volatile
than those in industrial countries.
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At the same time, it


is important to bear in mind that these markets are not
nearly as developed as those in the industrial countries.
To this extent, these markets may be more vulnerable to
speculative bubbles and wider price swings than might be
expected elsewhere.

Note also that the volatility in these

markets can be caused by volatility in developed country
markets, but the ripple effect is even greater.
Over the long-term, vulnerability to a change in
global interest rates or a change in portfolio preferences
can only be reduced by a country's success in eliminating
its external and internal imbalances--in short, by the
country's commitment to pursue sound macroeconomic policies
in a sustained way.

In today's markets, investors are

quick to shift out of a country's assets if they perceive
any worsening in its risk/return outlook.

It's that

A second difficulty is that, for some countries, the
surge in capital inflows has complicated the ability of the
monetary authorities to control domestic money and credit
growth and maintain exchange rates at a competitive level.
In such cases, these countries could confront a weakening
in the competitiveness of their exports in world markets
and a further widening in their current account deficits.
Policymakers have some options in dealing with these
problems, but all entail potential disadvantages.
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example, policymakers may opt to impose certain types of
capital restrictions, such as higher reserve requirements
or negative interest rates on nonresident bank deposits, to
help moderate the pace of the capital inflows.

But these

measures run the risk of distorting financial flows.


addition, policymakers can, in principle, intervene in the
foreign exchange market to sterilize the inflationary
effects of the capital inflows on the domestic money supply
and domestic credit growth.

This option, however, can

prove difficult to implement if financial markets are not
sufficiently developed.
Furthermore, how foreign capital is used will also
have a bearing on whether these inflows prove to be
beneficial or a burden.

In this connection, it is

particularly important that the bulk of the inflows are
used to promote domestic investment.

While investment

ratios in Latin America have certainly shown some increases
over the past few years, notably in Chile and Mexico,
investment still accounts for a much smaller share of GDP
in Latin America than it does in Asia--19 percent on
average in Latin America compared with 29 percent in Asia.
A third issue of some potential concern has to do
with the highly concentrated nature of the capital flowing
into Latin America today.

Some estimates show that in

1993, for example, over 80 percent of the fixed-income
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inflows were directed to three countries--Argentina,
Brazil, and Mexico.

Equity inflows appear to have been

similarly concentrated.

As more and more countries in the

region continue to deepen their reform efforts--and as the
investor base continues to widen--it is likely that capital
flows to Latin America will be distributed more broadly
throughout the region than has been the case to date.
Until a broader distribution of capital flows
occurs, however, financial support and policy advice from
the official international lending institutions remain as
crucial today as they have been in the past.


these institutions may also be helpful in exploring new
ways to join official with private finance to meet some of
the longer-term financing needs of all countries in the

The recent decision by the Inter-American

Development Bank to allow lending of up to 5 percent of its
capital to private borrowers without government guarantees
is a welcome step in this direction.
Finally, if they are to continue to attract foreign
capital, Latin American countries simply cannot relax their
commitment to economic and financial reform and structural

Although it is impossible to minimize the

remarkable accomplishments of so many countries--large and
small--in such a comparatively short period of time,
particularly considering how uncertain the outlook was only
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a decade ago, the agenda going forward is still daunting.
Let me cite just a few of the major challenges these
countries face:

To raise domestic savings--so as to reduce the
dependence on foreign capital--and to increase
domestic investment--so as to improve the
productivity of the economy, build a strong base
for export growth, and thereby ensure future
repayment capacity.


To strengthen the financial sector both by
deepening financial market reforms, thereby
developing more efficient money and capital
markets, and by improving prudential supervision
of the financial system.


To implement social measures--such as increased
attention to education, health care, low-cost
housing, and the environment--without widening
budget deficits and rekindling inflation.


To ensure that the gains of reform--that is, the
benefits of growth--are perceived to be
sufficiently widespread so as not to be
undermined by increased unemployment and social

In these efforts, governments must play a
constructive role.
Federal Reserve Bank of St. Louis

Markets by themselves simply will not



For us in the United States, it is especially

important that we raise our national saving rate by
encouraging private saving and continuing to contain and
lower our budget deficit.
Whether we like it or not, the world is a smaller
place today than ever before, and no more so than in the
world of trade and finance.

The technological revolution

of the past several decades has immutably altered the
nature of our interdependence within this hemisphere.


globalization of markets means that we are all affected
directly by changes in each other's economies.

The stakes

we have in each other's well-being are thus higher--and

Weakness or slackening in economic performance

can--and will--have ripple effects.
In my view, the main job each of us has in this
environment is to be aware of the impact our policies have
on each other and do our utmost to contribute to running
our own economies as wisely and as sensibly as we possibly
can--by sustaining policies that promote growth and contain
inflationary pressures.

The consequences of not pursuing

sound policies are increasingly more immediate:
capital, saving, and investment are affected.

flows of
The impact

on our economic prospects is direct.
In part because of the size of the U.S. economy and
in part because of the reserve currency role of the dollar,
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I believe that we in the United States have a special
responsibility in these respects.

I can assure you that,

for my part, I will do my very best to contribute to
whatever extent I can to meeting this commitment.

Thank you
Federal Reserve Bank of St. Louis