The provisions of the North American Free Trade Agreement as they relate to banking are quite extensive. The unfettered movement of investment capital across boundaries ushered in a new era of competition among banks in the North American region. The lifting of regulations by the Mexican government and the incorporation of economic stabilization and trade liberalization has provided the United States and Canada with increased access to the Mexican market. In order to facilitate a smooth transition for banks in the movement of investment capital across countries, NAFTA requires certain mandatory changes in the Mexican banking sector - primarily the removal of regulations and oversight. Mexico, almost simultaneously with the beginning of the NAFTA, negotiations began to deregulate the financial services sector to be in accordance with these demands. The short-term results of the policy were at first impressive, resulting in low inflation, fiscal balance, competition and attendant capital inflow. Yet, given the massive currency crisis that followed, the long-term sustainability of these policies is questionable. Even though NAFTA has carried out regulatory reforms in some financial sector services, it has not been successful in incorporating aggressive long-term reforms to the banking sector.
The lack of regulatory agencies overseeing the lending activities of banks remains a structural inefficiency of the banking sector. Any event that triggers the sudden outflow of capital is detrimental to a developing country that is hungry for investment and to the other economies with which it is interdependent. In both cases, lack of sophisticated regulatory institutions to oversee bank-lending activity creates long-term risks for sustainable economic development. This chapter will demonstrate the need for some regulation of the banking sector as it relates to capital flows. Since, the financial services chapter does not make the development of a regulatory framework a mandatory condition to joining NAFTA, its provisions can only provide short-term benefits. The NAFTA has undoubtedly helped improve capital flows across nations, which has provided benefits to member countries. This is because NAFTA has facilitated and improved cross-border security flows through its increased contact with the security markets. The formation of an agency comprised of financial experts from North, Central and South America has also helped the securities industry. However, because it failed to incorporate a supervisory agency to monitor the banking sector, the benefits of the existing reforms to the banking sector were short lived.
The failure to implement necessary regulations within NAFTA is best exemplified with the case of Mexico. Mexico, as a mandatory condition to joining NAFTA followed economic stabilization policies and privatized its financial services sector. These policies enhanced the short-term performance of the Mexican economy by lowering inflation and attaining fiscal balance. However, financial liberalization without a sophisticated framework in place can lead to a microeconomic financial crisis, as demonstrated by Mexico. A booming economy and aggressive bank lending practices blurs out risky borrowers from the legitimate. A regulatory agency can control activities of banks that are overly eager to lend money by establishing quotas and reserve requirements to deal with the problem. The lack of regulatory agencies to oversee the performance of the banking sector resulted in the 1994 debt crisis. The attendant inflow of capital and its subsequent outflow created instability in the financial sector. By examining the Chilean banking sector, this chapter will provide a framework for NAFTA to ameliorate some of the inimical effects of a deregulated banking sector. Chile serves as an excellent case study for the negative effects of unrestricted capital flows, as well as a positive example to improve these problems within the context of a free market environment.
During the initial NAFTA negotiations, Mexico started the deregulation of its financial services industry, a mandatory pre-requisite to joining NAFTA. Some of the important changes carried out by NAFTA included the establishment of domestic subsidiaries of banks in each member country, the granting of national treatment to foreign banks and extends most-favored-nation treatment to financial firms of member countries. This is seen within the text of NAFTA itself:
These provisions above fostered short-term competition among the three countries and also improved the performance of the Mexican economy. The provisions in financial services chapter have existed in the United States for a long time. The United States has looked favorably on providing MFN and national treatment to foreign banks since the 1900s, thus NAFTA simply extended this approach to Canada and Mexico.
Apart from the adoption of the required measures, countries are entitled to make certain allowances that are meant to protect the domestic consumers of financial services and the maintenance of the integrity of the financial market. Regulations within NAFTA, adapted from from the General Agreement on Trade and Tariffs (GATT), allows each NAFTA country to question the legality of an action if evidence points to violation of the NAFTA agreement. A panel of financial experts would settle the dispute. The Financial Services Committee of NAFTA would oversee the proper implementation of the provisions and should a dispute arise, a complaint would be brought before the committee. A problem with this mechanism, however, is the fact that only governments can bring complaints to other countries.
The United States banking industry has always been more liberal in its approach to banking that its counterparts in Canada and Mexico. Foreign banks have been allowed into the U.S. and treated as U.S. banks. Thus, for the U.S. government, the primary goal of NAFTA is to facilitate competition. According to testimony by John LaWare, before the Committee on Banking Finance and Urban Affairs, NAFTA does indeed serve U.S. interests in the financial services area.
The reforms undertaken by the Salinas administration to privatize the banking sector, has proved fruitful for the U.S. banks. Under NAFTA, U.S. banks are allowed to establish domestic bank subsidiaries. However, NAFTA also specifies that for the initial six years of the agreement, Mexico may regulate the size and share of foreign banks in the Mexican market. This will supposedly allow the Mexican economy to adjust to the structural and macroeconomic stabilization policies adopted in the mid-1980s. After the initial six-year period, if the U.S. and Canadian banks gain 25 ñ 30 percent of market share, NAFTA allows the Mexican government to further regulate foreign banks. However, these initial transition conditions do not constrain the competition of U.S. firms. As Barry Newman (1993) claims, these reforms and supposed restrictions of NAFTA actually strengthen U.S. market share. Clearly, NAFTA also goes a long ways to protect the U.S. financial system. Since the measures in NAFTA are already present in the United States, U.S. banks are already in a strong position to compete in newly deregulated markets, such as Mexico and Canada.
With NAFTA, there has been an increase in cross-border security transactions. Currently 290 Canadian companies and 12 Mexican companies are being traded on U.S. stock exchanges, including Mexico's state telephone company Telefones de Mexico. (4). Purchases and sales of Mexican securities by United States investors has jumped from $363 million in 1982 to over $19 billion in 1992. (5) As a result of the increased interaction among the three countries, the Securities and Exchange Commission (SEC) has strengthened its relations with the Canadian and Mexican securities industries, demonstrating the increased interdependence that has occurred since NAFTA's implementation... The SEC also has created the Council of Securities Regulators for the Americas comprised of security regulators from North, Central and South America, including Canada and Mexico. However, NAFTA lacks an agency similar to this to deal with problems specific to the banking sector.
Although the SEC is pursuing international initiatives that demonstrate increased interdependency, they assure U.S. investors that they need not be concerned about the erosion of domestic security markets. The U.S. securities market allows U.S. investors to benefit from growth of U.S. firms and also allows U.S. firms to raise capital to expand operations. As a result, it is necessary to preserve and maintain U.S. investors' confidence in the industry.
The U.S. securities industry will be minimally affected by the NAFTA and the provisions will go a long way to protect domestic investors:
The opportunities created for U.S. securities firms due to NAFTA are significant. Right now, U.S. securities firms find it difficult to cross barriers to enter the Mexican securities market. However, the signing of NAFTA will provide U.S. brokerage firms and mutual fund companies the opportunity to penetrate the Mexican securities industry. The NAFTA also allows the United States and Canada to acquire a Mexican securities firm and be entitled to the same national treatment accorded to Mexican firms.
The preceding sections discussed the financial services chapter of the NAFTA and the benefits the NAFTA has provided. The rest of the paper will address the success of the Mexican government's deregulation of financial services, stabilization policies and sustainability of these policies without a regulatory framework. President Salinas proposed the deregulation of Mexican banks in 1990. The highly regulated Mexican financial sector now had to privatize as per the guidelines that NAFTA had outlined. A paper produced by the Trade Commission of Mexico in Toronto, The Banking and Financial Industry in Mexico, states that the Mexican government began to sell its shares in the Mexican banking industry almost simultaneously with the opening of the NAFTA negotiations. Mexico's financial sector comprises commercial banks, national development banks, securities-brokerage houses, development trust funds and other non-bank institutions, such as insurance companies, bonding companies, foreign exchange houses, factoring companies, bonded warehouses, financial leasing companies and limited-scope financial institutions. (9) The major financial institutions in Mexico are the Ministry of Finance and Public Credit, Banco de Mexico, the National Banking Commission (CNB), the National Commission for the Retirement Savings System and the National Insurance and Bonding Commission.
The Ministry of Finance and Public Credit is authorized to formulate and coordinate Mexico's financial and fiscal policy. The Banco de Mexico primarily executes monetary policy and regulates the exchange rates. It is authorized by law to regulate for credit institutions and to provide discount facilities for certain types of bank loans. (10)
Of the remaining banks, six were scattered throughout the country, five were restricted to one region and the rest were multi-regional. Simultaneously with the opening of the NAFTA negotiations, on March 30, 1989, the Bank of Mexico liberalized interest rates and the lending and deposit operations. As a result, competition among the banks to attract funds increased. This competition increased bank lending activity and created a short-term investment boom in the Mexican economy. The "legal reserve" was eliminated and the approval of credit was channeled selectively. Domestic programs such as agriculture and housing development received most of the funds. The liquidity ratio dropped from 30 to 25 percent of assets held in government securities. (11) The ratio is expected to change and increase the amount of credit and assets available.
The policies followed by the Mexican government in the wake of the NAFTA agreement brought about major restructuring and stabilization in the Mexican economy. The short-run success of the Mexican government was evident soon after the proposal was made to deregulate the banking sector. The Canadian government had also seen success in the early 1980s when it liberalized its financial institutions. Prior to liberalization the economy was stagnant, there was instability in all sectors, inflation was high and the public sector debt was severe. The policies of the public sector, the oil crisis of the early 1980s and an increase in real international rates were attributed as the main causes of the economic problems. There were structural problems that were a result of state ownership of financial institutions that undermined the ability of banks to compete effectively. Restrictions on foreign ownership of banks also reduced competition.
The Mexican government adopted severe adjustment policies to correct the economic problems. The monetary and fiscal policies were tightened followed by a revision of wages and price control agreements among the government, business and labor. These measures considerably improved the immediate performance of the economy. There was a decrease in public sector expenditure characterized by a surplus in fiscal balance. In the late 1980s the Mexican economy was plagued by a public sector debt, where overall government spending was more than its revenues. The 1990 measures of the Mexican government improved the short-run productivity of the economy and there was a surge in government revenue.
In a budget sent to Congress by the Mexican government in November 1991, it was evident that the reforms followed by the government were extensive. The projected budget for 1992 showed a public sector surplus after the inclusion of foreign and domestic debt payments. The public sector surplus for 1992 was estimated at .8 percent of GDP. (12) The success of the Mexican government to obtain a fiscal balance continued to bring inflation down by one percent a month. The projected inflation for 1992 was only 10 percent and real GDP (adjusted for inflation) was expected to grow at a rate of 3.5 percent a year (See figure 1). (13) As a result of the inflow of capital, private investment was expected to grow by 12 percent a year. (14) With an increase in personal savings and large international reserves, banks extended credit to the private sector. The low level of inflation, greater economic stability and growth increased the demand or financial capital.
The macroeconomic stabilization policies of the Mexican government were complemented by massive structural reform. Trade liberalization, foreign investment promotion and privatization of state enterprises had to occur following the signing of the NAFTA.
Figure 1: Instituto Nacional de Estadistica, Geografia e Informatica cited in Barnes.
Foreign investment is important for the growth of any economy. To encourage foreign investment, the regulations were revised and administrative work was simplified to make investment easier. Deregulation facilitates competition which lowers the cost of doing business.
The NAFTA has provided American and Canadian banks with opportunities in Mexico at a crucial time in the banking industry. The opportunities come at a time when trade liberalization and expansion are being seriously considered. In October 1994, the Mexican Treasury approved the entry of 54 foreign financial firms and institutions. (15) These included 19 commercial banks, 16 stock brokerage firms, 12 insurance companies, five financial groups and two financial leasing firms. (16) The high ratio of the price-to-book value (the amount paid to acquire a bank as opposed to the market value) paid by the banks indicate the eagerness of private owners to lend to domestic and foreign investors. The surge of capital inflow into the Mexican economy resulted in a short-term boom in investment. Banks' eagerness to lend money increased speculation among local banks about the state of the economy. Bank owners believed the economy was booming due to demand for investment capital when in fact, the economy was booming only in the short-run as a result of opening the Mexican economy.
Despite the many short-term benefits created by liberalization and deregulation of the banking sector, Mexico's financial sector has been in trouble since the Mexican peso crisis. However, the roots of the crisis originated in the early 1990s with the privatization of the Mexican banking sector. The Mexican government did not institute a regulatory framework before deregulation. In 1994, the government estimated that repairing the financial sector would take close to 8% of Gross Domestic Product (GDP). (17)
As Gruben & McComb (1997) suggest, a recent literature has developed which deals with a financial industry crisis in a microeconomic context. According to this literature, financial liberalization is all the more inclined to cause a microeconomic financial crisis. Financial sector problems stem from a growing economy and aggressive bank lending practices. Heavy lending makes it increasingly difficult to identify risky borrowers. The problem becomes evident only after the eventual departure of foreign investment.
This same phenomenon is evident in the Mexican financial sector. With the signing of NAFTA, the provisions provided for easier capital flows. This led to the sudden rush of capital inflow and a subsequent departure of capital. In a similar study conducted in Canada following its liberalization policies in the 1980s, the same phenomenon was observed. There was a general eagerness among Canadian banks to lend in the short term hoping the returns in the long run would exceed short-term costs. In such a situation, one bank's actions can influence the actions of other banks, thereby creating indiscriminate lending.
One of the major benefits of a trade agreement between a developed and a developing country is that it provides the developing country with much needed capital. However, rapid inflow of capital resulting from a broad trade agreement like the NAFTA could have some undesirable side effects. The ability of the financial system to deal with these rapid changes can raise havoc in the functioning of the economy. Some major economic consequences of large capital inflows are real exchange rate appreciation, downturn in economic activity and employment, current accounts deficits, and increased pressures to abandon a semi-fixed exchange rate regime. (18) There are two things that developing countries must acquire in order to handle capital inflows and outflows effectively. First, the financial system has to be stable enough to handle sudden inflows of capital. Second, regulatory structures must be present to oversee financial institutions. Capital inflows increase the accessibility of financial resources for financial institutions to intermediate. Financial crisis could result as a consequence of bad lending practices.
In the period extending from 1983-1989 capital inflows to emerging markets averaged $10 billion per year; this figure grew to $155 billion in 1993. (19) A lot of the emerging literature has pointed to reduction of interest rates in the developed countries as the primary reason for the flow of capital into developing countries. The probability of financial crisis has gotten significantly higher because of the changes countries now see in the ease and mobility of capital flows. Commercial banks are not the only institutions providing investors with foreign capital; there has also been a proliferation of institutional investors that have contributed to the surge in capital flows. Emerging markets are prone to massive shifts from negative to positive equilibrium.
Capital inflow into a developing economy increases the number of resources being pumped into the economy. A large increase in resources all at once might be too overwhelming for a developing country. An increase in the amount of loans awarded could blur the risky borrowers from the legitimate.
In November 1982, then President Lopez Portillo regulated the banking industry to counter the economic decline Mexico was experiencing. The events leading up to the nationalization of the banking sector are interesting. There was a high rate of capital flight from Mexico and to harness a better control of the financial sector, Portillo nationalized the banks. Capital flight is a phenomenon associated with economic conditions within a country, not with bank structure. To make sure that the banks stayed regulated, a constitutional amendment was added to the Mexican constitution giving the President full control of the financial system. Of the original 58 banks only 18 remained. (20) There was a financial crisis prior to the privatization including high government debt. In an effort to reduce domestic debt, the government imposed high reserve requirements. The government controlled the private lending functions of banks and raising the reserve ratio led to insufficient consumer lending. The only way the banks were allowed to fulfill certain private loans was by buying government debt. A government statistic in 1986 showed 60% of net bank credit loaned to the government. (21) The government decreed preferential lending and controlled ceilings on interest rates and bank assets. In 1982, Miguel de la Madrid Hurtado replaced Lopez Portillo. The banks remained privatized under his administration but de la Madrid did renovate the bond market for debt repayment. In order to wean the government away from banks, de la Madrid introduced cetes (peso-denominated bonds). These bonds were specifically used for the purpose of debt repayment. It was a concerted effort by the administration to wean the government from its dependency of banks. Since the government was no longer dependent on banks, the commercial banks were privatized under the Carlos Salinas de Gortari administration in 1990. The lending quota was now eliminated and the reserve ratio was not a requirement anymore.
The Mexican government managed to sell all of the 18 nationalized banks to private Mexican's within a span of two years after privatization. Only three banks held most of the bank assets. By 1994, with the entry of new domestic competitors, the number of banks in Mexico numbered 35. (22) Foreign banks were allowed in shortly after the ratification of the NAFTA. At first, the banks did extremely well, their profits averaging above those of the U.S. and Canada. With the signing of the NAFTA and the surge of investment opportunities, the banks were eager to lend money. With no required reserves and lending quotas, the banks lent more than what they could afford to lend, in the hope of acquiring huge profits later. The bank depositors were paid lower interest rates while interest on loans were hiked up more than costs. Thus, this means that at the time of issuing the loans banks charged borrowers higher interest rates in the hope of reaping profits later.
The exchange rate crisis in 1994 was in large part a result of the inefficient function of the banking sector. In 1988, with the commencement of the Salinas administration, the rationalization of Mexico's fiscal, monetary, financial, investment, and trade policies - together with relatively high real interest rates in Mexico and low rates in the United States - precipitated large inflows of foreign capital. (23) In the first four years after nationalization, the Mexican reserves of foreign currency spiraled from less than $5 billion in 1990 to nearly $30 billion in 1994. (24) This was very encouraging and therefore investor optimism in the economy also grew. The confidence was further displayed when investors were unshaken by the rebel take over of San Cristobal de las Casas in January 1994. However, later that year the assassination of an Institutional Revolutionary Party leader, caused a frantic outflow of capital. Soon thereafter, reserves of foreign currency in banks began to fall and by the end of November 1994, reserves were down to $12.889 billion. (25) The Mexican economy could not support the peso and the government devalued the peso in late December, which further hurt consumer confidence in the peso.
With reserves down to a mere $13 billion and the expected maturity of $17 billion worth of dollar indexed, peso-denominated bonds (tesobonos) by mid-1995, the Mexican government panicked. (26) Tesobonos are short-term Mexican, dollar-indexed bonds mainly held by overseas investors. Apart from the expected maturity of bonds, $28 billion worth of bonds were still trading and of this, foreign investors held $17 billion. (27) Foreign reserves were not growing and there was an expected run on the peso. The government was forced to adopt a floating exchange rate system. By the last week of December 1994, the peso closed at 5.075 pesos to a dollar. (28) The tesobonos were now convertible at the official free-exchange rate. Mexico was also $28 billion in debt to foreign banks that were to be repaid in 1995. (29) Between $5 billion and $10 billion in tesobonos were used by Mexican banks as collateral to get dollar credit from foreign banks (See Figure 2). (30) Most of the debts were backed by tesobono bonds, which were pegged to the dollar but were to be repaid in pesos. This led to a further devaluation of the peso, which now was at a ratio of five pesos to a dollar. By the end of December, foreign currency reserves fell to $4.440 billion. (31) The Mexican economy was now in trouble.
Figure 2: Data: Mexican Central Bank cited in Smith (June 1995), Pulling the Banks from the Rubble, p. 52.
As a result of the capital outflows and the high inflation rates, the central bank increased interest rates putting borrowers at risk but that also increased the loan default rate. The banks faced increasing problems as more consumers defaulted on loans. The banks also suspended all loans including mortgage, auto, and agriculture loans. Many banks failed including, Banca Cremi, Banco Union and Banpais, three of the 18 banks that were regulated and then privatized in 1990. The government spent $1.2 billion to rescue the Banca Cremi and Banco Union. (32) Due to the peso crisis, exporters and business that wanted to take advantage of the NAFTA environment did not get affordable loans. Mexican manufacturers who wanted to modernize were helpless without any source of funding for these programs. The austerity measures adopted by the Mexican government in 1990 were now causing business and consumer interest rates on loans nearing the triple digits; banks were heading for massive failure. The U.S. had to extend a $40 billion aid package to rescue Mexico.
One of the "prudential" caveats of the NAFTA allows a six year transition period since its inception, that would let a Canadian or U.S. bank to acquire a Mexican bank only if it did not account for more than 1.5 percent of total Mexican bank capital. (33) In December 1994, only two Mexican banks met the condition.
The Mexican banks did not pay significant attention to consumer credit assessments in making loans. The extension of loans to an unrestricted number of customers and an devaluation of the Mexican currency, led to loan defaults. The increasing amount of capital flows into the region and favorable lending practices of banks masked otherwise risky borrowers, from the credible. As the number of banks lending capital increased, so did speculative behavior and that further aggravated the problem.
Financial liberalization in a developing country more often than not leads to aggressive lending practices. The difference in the cost of funds and the interest rates on loans are enormous. The lack of regulatory structures becomes apparent due to lack of expertise, qualified human resources, and adequate technology. (34)
A high ratio of the price-to-book value paid for a bank can indicate the eagerness of bank owners to compete in the Mexican financial sector. It can also indicate that Mexican owners are eager to acquire the largest market share without any regard to the kind of creditors to whom they are making loans.
Chile's financial liberalization in the 1970s, given the debt crisis in 1982, and the subsequent regulatory measures taken by the Chilean government to ease the transition to deregulation can provide the NAFTA countries with some clear ways of preventing a repeat of the financial crisis that rippled through the Mexican economy in 1994. Chile deregulated its financial sector in the mid-1970s. (35) The deregulation of interest rates caused an increase in real interest rates. The opening of the capital market to foreign investment did not reduce the interest rates as would normally be expected. The underlying reason behind persistent high interest rates was because of loan defaults by risky borrowers, a phenomenon similar to the Mexican peso crisis. The result was the debt crisis that emerged in Chile in the 1980s. The poorly managed financial sector was accessible to the domestic economy before a strong regulatory framework was instated in Chile. The lesson that we can draw from the Chilean financial crisis is that a regulatory institution must be in place in order for financial liberalization to be a success. Competition cannot be fostered in an economy that has a very poorly regulated financial system. In order for financial liberalization to have its intended effect, a regulatory structure must be put in place to avert the risk of a major financial crisis in the future.
In the mid-1980s after Chile recovered from the debt crisis, the government worked to include some "prudential" regulations into the financial sector. In order to strengthen the financial market before international integration, the Chilean government did not allow unsupervised lending, especially to countries that were heavily indebted. Instead, the banking sector was regulated and deepened to increase the efficiency of the financial sector. The performance of the Chilean banking sector was significant and the figures indicating increases in net capital flows are notable. Between 1990 and 1994, net capital flows increased 7% without undermining the stability of the Chilean economy. (36) The financial institutions showed a low-risk portfolio of assets. The percentage of past-due loans over loans went from 2% in December of 1990 to 1% in December of 1995.(37)
In a country as small as Chile unregulated capital inflows, though often beneficial, can disturb the normal functioning of the economy. When these capital inflows are matched by capital outflows, even small disturbances can contribute to the instability in the economy. Investors might eventually be deterred from investing once the risk factor increases and capital flows out. The problem lies in the magnitude and volatility of investment and the ability of the developing country to deal with capital flows.
In order to handle capital flows effectively, Chile took measures to protect itself from a financial crisis. Chile instituted restrictions on capital inflows with the establishment of reserve requirements. However, in Mexico, the deregulation of the financial sector was followed by the abolition of the required reserve.
Capital flows allowed in indiscriminately are the principle cause of bank failures. In order to restrict capital inflows, the Chilean government put restrictions on short-term inflows of capital. The idea was to make short-term investment in Chile more expensive. Short-term surges in capital inflow can cause speculation among bankers and volatility in the capital market. When short-term flows are avoided speculation is reduced due to a decrease in the amount of short-term capital flows, which mislead investors into thinking that the economy is booming and investment is flooding in. Instead, the Chilean government gave priority to investors who were committed to being in Chile for at least one year. (38) Chilean citizens were also encouraged to invest in foreign firms to increase capital outflows. However, banks and other financial institutions were restricted to limited foreign investment in an effort to prevent excessive risk taking.
Apart from the regulations prescribed for capital flows, the Chilean government also instituted a regulatory framework to oversee bank lending activity. The supervisory work was carried out by the Superintendency of Banks and Financial Institution in Chile (SBIF). The SBIF was given by law certain powers that it can exercise if a rule is violated. Some of the prerogatives include reprimands, censure, fines, restricting certain operations, appointing a delegate inspector, taking over the management of an institution, or even closing it down. (39) Incorporation of the SBIF has created transparency in the financial sector. The SBIF has disclosed to the public, especially investors, with statistical data on the performance of each financial institution. This allows investors to form their own opinions on the status of banks, thereby further boosting investor confidence in the financial sector.
Competition among the financial sectors of the NAFTA countries is imperative. However, a developing country like Mexico, must to be able to withstand the increased international competition in order to reap the benefits of competition. In order to institute an effective supervisory agency, there needs to be a strong regulatory framework created before broad integration can take place. In addition, these agencies must be comprised of experienced individuals who are capable of performing their duties on a long-term basis. Lastly, the agency must be able to detect a crisis before it erupts and causes financial instability in the country.
The development of competition among the three NAFTA countries is undoubtedly a positive aspect of the NAFTA. However, the benefits of competition are undermined by the costs. Had there been a regulatory framework in place after financial liberalization of the Mexican economy, it can be argued that Mexico would not have experienced a financial crisis to the extent that it did in 1994. A certain degree of instability might have been present but the complete failure of financial institutions and the necessity for the United States to bailout Mexico could have been averted.
Many of the problems of the banking sector stem from indiscriminate lending to risky creditors. To mitigate the potentiality of a financial crisis by heavy unrestricted lending, banks could extend other forms of credit to those who undermine the stability of banks. One form of credit is microcredit or microlending, which allows lenders to make small loans to talented entrepreneurs at the lowest rungs of society at below market interest rates. (40) Since the borrowers can offer no collateral, the lenders offer credit to groups of people. The borrowers collateralize each other, whereby if one of them defaults on a loan all are penalized by forfeiting their chance of ever receiving another loan. First experimented by a Bangladeshi economics professor in 1976, microcredit has gained much ground since it was first initiated. He founded the Grameen Bank, the first microcredit bank that has now helped one third of its clients cross the poverty line. (41) In 1996, the bank reported making a total of $1 billion in loans to the poor with a 98% repayment rate. (42)
Instead of having commercial banks in charge of lending to risky investors, responsibility can be handed over to a microcredit institution that will more carefully oversee repayment of loans. This will automatically eliminate the presence of risky borrowers going to commercial banks for loans to start new businesses.
When Mexico liberalized its financial sector, the demand for credit led to an increase in interest rates. Indiscriminate lending by banks led to loan defaults by risky borrowers, mostly Mexican citizens interested in starting businesses to take advantage of favorable economic conditions. As a result of the Mexican financial crisis, banks stopped making loans to entrepreneurs and farmers who wanted capital to buy fertilizer. Microcredit would have been a good way for the poor to start up businesses and for farmers to buy fertilizer. Microlending will allow people of lower economic status to reap the benefits of increased competition.
Microlending institutions have increased significantly in two decades, since the program was first started. Six thousand microlending institutions, which include charitable foundations, government agencies and nonprofit groups, now reach 8 million people on 6 continents. (43) Microlending is clearly a virtue that the talented poor can use to bring themselves up and serve as a role model for the rest of the community.
There were many improvements to the Mexican banking system. Not only had privatization been incorporated but the Mexican government also managed to wean itself away from dependency on banks for financing the national debt. The number of banks had also increased substantially as a result of deregulation. The overnight competition that developed among the banks created a struggle for market share and the subsequent aggressive lending practices. Because of the lack of a regulatory structure overseeing the lending policies, banks fell victim to the weaknesses in the financial system.
The currency crisis of 1994 clearly demonstrates the vulnerability of developing countries to an attendant inflow of capital and a subsequent outflow of capital. It only takes one shock to trigger the events that rippled through the Mexican economy in 1994. Investor confidence in any economy, especially a developing one is important to sustain the growth of a developing economy. The stabilization policies pursued by Mexico in the wake of the NAFTA agreement were attempted in the hope that neoliberal policies emphasizing free trade and free movement of capital would lead to short term as well as long term benefits to the Mexican economy. However, these hopes were unrealistic to a country that did not have the necessary regulatory institutions to carry out policies of such scope.
Learning from the failures and successes of the Chilean banking sector is a good way to begin the process of restructuring the NAFTA financial system by implementing a regulatory framework that oversees the financial activity in all NAFTA countries, especially the developing countries like Mexico. Free trade has provided all NAFTA countries with significant opportunities to improve relations and foster competition among the three countries. However, competition cannot survive in a system where one country is not able to compete effectively with the others. Reforming the NAFTA by instituting the suggested solution of the Chilean banking sector is one way of starting the deepening process before it can be widened to the rest of South America.