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Exchange Rate Politics in Latin America


Most of the analysis of Latin American exchange rate problems and policies has concentrated on the economic side of things. This volume instead examines the politics of exchange rate management in four nations that had very different approaches and results. Although the Mexican peso crash, Brazil's currency crisis, Argentina's maintenance of a currency board, and Venezuelan policy responses to the shocks of 1997-98 have had major international financial ramifications, the origins and outcomes of these dramatic ...

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Most of the analysis of Latin American exchange rate problems and policies has concentrated on the economic side of things. This volume instead examines the politics of exchange rate management in four nations that had very different approaches and results. Although the Mexican peso crash, Brazil's currency crisis, Argentina's maintenance of a currency board, and Venezuelan policy responses to the shocks of 1997-98 have had major international financial ramifications, the origins and outcomes of these dramatic events have yet to be analyzed in a single volume. The contributors tie these policy episodes together using solid comparative analysis, in order to better inform the policy debate on these issues.

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Editorial Reviews

From the Publisher

"... timely and elegantly written." —Carlos Santiso, Johns Hopkins University, Latin American Studies, vol. 34, 2002

"A welcome contribution to a policy area that has not recieved due scholarly attention among Latin Americanists. Few policy areas bring to light so clearly the tradeoffs and tensions that exist between economics and politics." —Omar Sanchez, University of Oxford, Journal of Development Studies, 12/1/2001

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Product Details

  • ISBN-13: 9780815794875
  • Publisher: Brookings Institution Press
  • Publication date: 10/28/2000
  • Pages: 160
  • Product dimensions: 5.96 (w) x 8.98 (h) x 0.51 (d)

Meet the Author

Carol Wise is associate professor of international relations at the University of Southern California. Her most recent books include Reinventing the State: Economic Strategy and Institutional Change in Peru (Michigan, 2003) and with Riordan Roett, Post Stabilization Politics in Latin America: Competition, Transition, Collapse (Brookings, 2003).

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Exchange Rate Politics in Latin America

Edited by Carol Wise and Riordan Roett

Brookings Institution Press

Copyright © 2000 The Brookings Institution Press.
All rights reserved.
ISBN: 0815794878

Chapter One

Introduction: Debates,
Performance, and the
Politics of Policy Choice


Just as the Great Depression of the 1930s triggered dramatic economic and political changes in Latin America, so too did the next major regionwide downturn—the 1982 debt shocks and the deep recession that persisted for the remainder of that decade. However, while the former crisis set the stage for nearly five decades of protectionism and populism in Latin America, the latter prompted the opposite response. Having found out the hard way that the world economy of the late twentieth century was a much different place to do business, a new generation of Latin American politicians and policymakers came to embrace deep market reforms by 1990. In turn, the steep reduction in barriers for trade and finance quickened the region's integration into international markets, where a boom in the flow of goods and capital had long been under way. As a result, the total volume of Latin America's trade doubled through the course of the 1990s, and between 1990 and 1996 leading emerging-market countries like Argentina, Brazil, and Mexico saw a sixfold increase in net capital flows, including portfolio flows (bonds and equities) and foreign direct investment (FDI). This stands in stark contrast to the net negative outflows of capital that the region registered during the 1980s.

    Despite this remarkable turnaround, the last decade has also shown that greater international exposure gives rise to more rigorous demands for coherent and credible macroeconomic policies. In short, whereas pre-1982 attitudes toward macroeconomic policy in Latin America basically amounted to a strategy of benign neglect, this option was foreclosed by the exigencies of the external sector in the wake of widespread market reforms. Predictably, debates over macroeconomic policy became more politically charged. Decisions concerning trade negotiations or options for regional integration schemes became more contentious, as did efforts to resolve the kinds of currency crises and financial market stress that have intermittently plagued Argentina, Brazil, Mexico, and Venezuela—the four countries considered in this volume—since 1994. As Jeffry Frieden has observed, "increased levels of financial and commercial integration drive monetary policy toward the exchange rate, make the exchange rate more distributionally divisive, and lead to a more politicized context for the making of macroeconomic policy."

    This collection of essays examines the rise of a more politicized context for macroeconomic policymaking in Latin America from the standpoint of exchange rate management. Defined here as the price of a country's currency expressed in terms of other currencies or gold, the exchange rate has a direct impact on a wide range of relative prices. Admittedly, all macroeconomic policies are important, but under today's conditions of unprecedented commercial and financial openness in the region, changes in the level and stability of the exchange rate can more readily affect growth, employment, inflation, and other key economic indicators (for example, the relative price of goods, labor, and financial assets). Interestingly, despite a strong consensus regarding the importance of currency policy and the breadth of its impact, little attention has been paid to the role of politics in the choice and sustainability of a given exchange rate regime. Mexico, as the first Latin American country to experience a full-blown exchange rate crisis in the current era of market reform, has been most closely scrutinized. Given the prominent role that politics has been assigned in provoking that crisis, the purpose of this volume is to expand the analysis of exchange rate politics to other countries in the region.

    I begin with a fairly simple set of questions. What are the main debates that have surrounded exchange rate policy since the advent of market reforms in Latin America? In comparing economic performance across the four countries considered here, what political economy lessons can be gleaned from the standpoint of exchange rate management? If politics is indeed relevant, what are the main societal factors and institutional mechanisms by which it has been brought to bear on macroeconomic decisionmaking? These questions are briefly explored below.

The Main Debates

Two overlapping themes have characterized the debate over exchange rate policy in Latin America since the widespread implementation of market reforms. The first regards the kind of exchange rate regime that would best complement the new liberal economic model. Opinions differ widely, for the liberal economic paradigm offers no clear guidance. For instance, two Nobel Prize-winning liberal economists, Milton Friedman and Robert Mundell, have argued respectively for a freely floating exchange rate and a rate fixed to the gold standard. Debates about exchange rates have remained a steady feature of the post-Bretton Woods shift from fixed to flexible currency arrangements, but Latin America's overt struggle with these issues in the context of more open economies has revived earlier discussions about policy choice in the region.

    The radically changed development strategies of Latin American countries have also given rise to new challenges; a second theme to emerge over the past decade concerns how exchange rate policy can better cope with new pressures. Specifically, the liberalization of the current and capital account has created additional pressures toward exchange rate appreciation. When capital flows accelerate and the exchange rate fails to adjust accordingly, inflationary pressures mount and the real exchange rate will appreciate through higher domestic inflation. Within this scenario, a familiar regional pattern in the 1990s has been the growing tendency toward current account deficits and the increased reliance on portfolio flows and high interest rates to attract additional capital to finance those deficits. The pressure toward currency appreciation under these circumstances has remained steady regardless of the various exchange rate regimes that have been adopted.

    The bottom line appears to be a given government's political commitment to implement the domestic policies necessary to sustain the currency at a competitive level. At any rate, as these emerging-market countries have harnessed their economic fate more directly to the external sector through the active promotion of exports and FDI, exchange rate appreciation works to undermine efforts at more successful integration into international markets.

    The range of exchange rate options embraced by the leading Latin American economies over the past decade is mapped out in figure 1-1. As the figure shows, there are few alternatives that Latin American policymakers have not tried. The figure corresponds with the three main regimes that Max Corden discusses in his overview chapter: the firmly fixed rate regime, the fixed but adjustable rate regime (FBAR), and the floating rate regime. The left end of this continuum can be characterized as the nominal anchor approach, where a fixed or crawling peg exchange rate is used to exert downward pressure on a country's inflation rate. At the right end of the continuum lies the real targets approach, where the nominal exchange rate is used to achieve such targets as higher employment or a turnaround in the current account. Corden cautions that "no regime has only advantages or disadvantages—trade-offs are always involved.... [M]any regimes are possible and can appear successful provided there is no major shock."

    Nevertheless, the literature is full of arguments in defense of one strategy over the other. Given Latin America's strong and patently unsuccessful reliance on FBAR regimes throughout most of the post-World War II period, common wisdom in the 1990s has increasingly discounted this intermediate strategy as obsolete. Such intermediate regimes are no longer viable under conditions of high capital mobility and tightly knit patterns of international financial integration, so the argument goes. In other words, countries are faced with the choice of fixed (Argentina) versus floating (Mexico) rates. Yet there are clear exceptions to this notion of a disappearing middle ground, the case of Chile being a main one.

    With its longer timeline on liberalization, and its rock-solid macroeconomic fundamentals in the post-1982 period, Chile has been the region's stellar performer for nearly two decades. A main fundamental has been the exchange rate, which until 1998 consisted of a nominal rate system based on a crawling band. Chile's exchange rate band, in conjunction with minimum stay requirements for FDI and nonremunerated reserve requirements for other forms of capital inflows, enabled the economy to withstand external shocks such as Mexico's currency crisis in late 1994. It also formed the linchpin of an economic strategy that sought quite effectively to promote high growth and low inflation through aggressive export expansion. (The Chilean case was not included in this project because it has already been so thoroughly studied.) Suffice it to say here that Chile's main responses to the Asian, Russian, and Brazilian shocks of 1997-98—the shift to a floating rate and the abandonment of capital controls—are testimony not to the discovery of a "better" exchange rate policy, but rather to policymakers' recognition that changing international circumstances warranted a different course of action on the domestic front.

    Although the very diversity of options that have been embraced in Latin America under the intermediate banner (for example, crawling pegs, bands, currency baskets) makes it difficult to specify the trade-offs, these stand out more clearly at either end of the continuum in figure 1-1. On the side of fixed exchange rates, the advantages lie in the government's enhanced credibility by way of greater macroeconomic discipline and inflation reduction; the trade-off concerns the extent to which the welfare of the domestic economy comes to depend on trends in the external sector, especially under conditions of high capital mobility and volatile financial flows. As for flexible or floating currencies, the benefits lie in the exchange rate system's ability to adjust for shifts in competitiveness, to absorb real external shocks, and to mitigate both incoming and outgoing capital surges; the risks are a greater susceptibility to erratic exchange rate swings that place stress on the tradable sector, and the temptation for governments to ease up on fiscal and monetary discipline in the absence of a nominal anchor.

    Again, these trade-offs make it difficult to argue for the superiority of one regime over another. The shifting policy choices reflected in figure 1-1 suggest that a regime that is deemed appropriate at one point in time may simply not be as viable at a later point. In this collection of case studies we argue that the moment of truth—to adjust or defend the exchange rate—is more than just a technical matter. Rather, it is also a political decision, and one that goes to the heart of a country's commitment to succeed in implementing the policies necessary to sustain the regime that has been chosen.

Macroeconomic Performance and Empirical Realities in the 1990s

The four countries included in this study were chosen for several reasons. First, as the four largest economies in the region, these cases are roughly similar with regard to their status as emerging-market, or middle-income developing, countries. Moreover, at the very least the term emerging-market implies that all four have made considerable headway in the implementation of liberal economic reforms. Although Venezuela's market reform effort was waylaid by domestic politics midway through the 1990s, as Javier Corrales points out in his chapter, policymakers still managed to preserve important institutional mechanisms that helped to rationalize exchange rate policy.

    However, despite their similar status, the four cases differ considerably on the dependent variable: choice of exchange rate regime. As figure 1-1 shows, Mexico and Brazil are on relatively new terrain with their flexible exchange rate regimes, while Argentina is on fairly extreme ground with its exchange rate fixed tightly to the U.S. dollar under a currency board. Finally, Venezuela remains in the intermediate range with its exchange rate band. The main departure point for the analyses in this book is this variation in national policy responses, which is ascribed to the kinds of political pressures that affect domestic policymakers.

    Just as the choice of an appropriate exchange rate system has elicited differing views, so too has the question of macroeconomic performance under a given currency regime. Chile's success under an intermediate exchange rate policy has drawn the widest consensus, but after agreeing on this, policy analysts have quickly parted ways. From the extensive political economy literature on Latin America, it is possible to find convincing empirical arguments for each end of the exchange rate continuum presented in figure 1-1. For example, in defense of more flexible arrangements, one recent survey of some twenty-five stabilization episodes in the region found that only a third of those based on a nominal exchange rate anchor were successful; the more common outcome was for fixed exchange rates to give way in the face of continued inflation, as opposed to stabilizing prices.

    Yet the evidence is ambiguous. Recent studies conducted by researchers at the Inter-American Development Bank (IDB) reassessed the supposed benefits of greater exchange rate flexibility: on all fronts—from the ability to better absorb external shocks to greater ease in adjusting to shifts in competitiveness—a more flexible regime was found to be equally wanting. As the IDB's former chief economist, Ricardo Hausmann, summarized the findings: "Flexible exchange regimes have not permitted a more stabilizing monetary policy and have tended to be more procyclical. Moreover, flexible regimes have resulted in higher real interest rates, smaller financial systems and domestic interest rates that are more sensitive to movements in international rates. Flexible regimes also tend to promote wage indexation. Worse yet, while flexible regimes are billed as a means of maintaining competitiveness, the revealed preference of Latin America is to allow very little exchange rate movement, even in periods of large real shocks such as 1998."

    In light of these trends, and in recognition that "fixed exchange rates are never fixed for long," the IDB project explores proposals for dollarization—the ultimate precommitment that a major devaluation will not occur. This volume tackles the question of dollarization only in passing. First, it is still too early in the game to speak definitively about this policy option. Some of the proposals coming from Latin America (Argentina, Ecuador, El Salvador, and several other Central American countries) in the wake of the Brazilian crisis show promise; in the event that they become a reality, the advent of dollarization in Latin America would warrant another collection of essays. But second, it is still not clear if the necessary political constituency exists within the United States to advance dollarization in the Western Hemisphere.

    If neither the debates nor the data offer much in the way of lasting "empirical realities," the shift toward greater exchange rate flexibility is indeed an unmistakable trend across the developing world. Whereas pegged rates prevailed in 87 percent of developing countries in 1975, by the mid-1990s this figure had dropped below 50 percent. In Latin America, where this shift has unfolded in two stages, the trend toward flexibility has been more pronounced. In the early stages of adjustment following the 1982 debt shocks, high inflationary pressures and extremely low credibility rendered a fixed or semifixed regime the more sensible choice. Yet as inflation subsided, growth recovered, and fiscal and monetary reforms were implemented, a more flexible system made better sense. Apart from the costs and benefits reviewed earlier, the trend toward more flexible rates has been generally associated with the liberalization of trade and investment in the 1990s, and with the stronger emphasis on market-driven currencies and interest rates.

    The data in table 1-1 reflect the macroeconomic trends that have underpinned this shift toward greater exchange rate flexibility in all but the Argentine case. As can be seen from the five-country comparison, by the mid-1990s inflation was finally under control (with the regional average below 9 percent by 1999), growth had been restored to varying degrees, and government finances were much improved in three of the five cases. Thus by mid-decade, Argentina and Mexico had joined Chile in achieving the goals of monetary stability and enhanced credibility that are most associated with a fixed or semifixed rate. At the same time, however, the running deficit in the trade balance and the current account reflects the continued pressure and volatility that these countries face on the external front. The tendency in all five cases has been to linger too long with an appreciated and artificially strong exchange rate, at least until unmanageable external shocks prompted a currency crisis.

    This is just what occurred, for example, when Chile's exchange rate crashed under the force of the 1982 debt shocks, the Mexican peso fell in the face of reckless private borrowing and massive capital outflows in 1994, and the Brazilian real buckled in late 1998 under the weight of fiscal mismanagement and contagion from crises erupting in Asia and Russia. In these cases, as in Venezuela, a choice of greater exchange rate flexibility was the immediate outcome of financial crisis. As figure 1-1 shows, only Argentina has held the line in defending a fixed exchange rate in the 1990s, despite its exposure to these same patterns of financial contagion and volatility in international capital flows. Nevertheless, this clear shift toward greater flexibility should not be taken as an indictment against fixed rates: the data continue to confirm that currency misalignments and financial blowups are equally likely under fixed and flexible arrangements. For example, between 1975 and 1996, in a sample of 116 developing country cases where the exchange rate fell at least 25 percent in one year, nearly half of these major adjustments occurred under flexible regimes. At the end of the day, success or failure seems to depend as much on policymakers' tenacity and the ability of political leaders to garner broad support for the chosen strategy as it does on the technicalities of macroeconomic policymaking.

Exchange Rate Politics

This study approaches the question of exchange rate politics from two angles. First, it considers the conflicting pressures that special interests exert on political leaders and policy officials in demanding that the exchange rate be maintained at a certain level. The exchange rate preferences of special interests in the four Latin American countries studied here tend to fall roughly along the following lines. Traditionally, domestic producers in Latin America have been the most vociferous and the most divided in stating their currency preferences. Those producing for export prefer a depreciated but predictable exchange rate policy, while those involved in production for the home market are prone to push for a more flexible monetary policy overall, including an adjustable exchange rate. International investors clearly side with exporting interests in their demands for stable and predictable prices. In the wake of the high inflation rates that prevailed until the 1990s, workers and middle-class consumers have come to prefer overvalued fixed rates, which they associate with enhanced purchasing power (cheaper domestic credit and ready access to affordable imported goods).

    Second, this book considers the broader political coalitions and institutional mechanisms through which monetary policy is mediated. The approach to this second question is portrayed in figure 1-2, which suggests a shift toward increased reliance on societal intermediation over the past decade—through legislatures, business chambers, labor organizations, political parties, and consumers-at-large—in the execution of exchange rate policy. In essence, during the initial phase of market reform in Latin America, policymakers moved swiftly and somewhat autocratically in launching stabilization programs that sought to combat prohibitively high inflation rates through the use of fixed exchange rates. As the goals of a nominal anchor were gradually achieved (price stability and greater credibility) in Argentina, Brazil, and Mexico, along with the completion of crucial first-phase market reforms based on liberalization, privatization, and deregulation, the tasks of economic management changed.

    By the mid-1990s, although Venezuela had yet to fully advance on these first-phase reforms, the other three countries faced two kinds of second-phase reform challenges: the need to further deepen market initiatives in areas that lagged (labor market reforms, fiscal modernization at the municipal level), and the need to strengthen the institutional backdrop that supports market reform (more stringent defense of property rights, more authentic regulatory and oversight mechanisms). With regard to exchange rate management, the advent of second-phase reforms meant that the overall economic fundamentals were now sound enough to signal a lasting commitment to low inflation. Despite the heated debates in the literature over where to proceed from here, and the failure thus far to identify a graceful exit strategy from the nominal anchor, some argued convincingly for greater flexibility on the grounds that "after these initial objectives are achieved, and once the fiscal and monetary sides are under control, a switch of anchor will be called for, and a more flexible system—either a managed float or a crawling peg—should be adopted."

    But paradoxically, while greater exchange rate flexibility, or the process of allowing the market to determine the relative value of the currency, may imply a hands-off political strategy, just the opposite is true. If anything, politicians and policymakers have been increasingly careful to woo special interests and to offer a wide range of compensatory perks in order to maintain political support over time. This compensatory imperative stems both from the more intense levels of economic competition to which all segments of civil society have been exposed in the era of market reform (and thus the need to offer some respite to the losers in the reform process) and from the inability of flexible rates to fully buffer and absorb the highly volatile external shocks that have occurred in rapid fire beginning with Mexico's 1994 crash.

    The four case studies in this volume probe the ways in which domestic politics has tipped the balance in favor of a particular exchange rate regime in the 1990s. Although Mexico and Brazil indeed opted for greater exchange rate flexibility, as one prominent strand of macroeconomic thinking has recommended they should, why did it take a massive financial crisis to wrest an anchored regime from the hands of policymakers in both countries? Conversely, how is it that Argentina has held the line on a fixed rate regime, despite the costs of austerity, deflation, and double-digit unemployment? Finally, why has Venezuela dragged its heels for so long in maintaining a defensive macroeconomic strategy that no one recommends, mainly because of its strong association with the lackluster prereform period in Latin America? In all four of the country chapters, the role of special interests, domestic institutions, and old-fashioned statecraft in shaping these diverse responses to similar external contingencies are explored.

    In his chapter on Mexico, Tim Kessler attributes the Salinas administration's rigid policy stance to the numerous political-economic contradictions that the ruling party (PRI) had itself cultivated over the course of Salinas's term (1988-94). On the domestic front, the anchoring of the nominal exchange rate in conjunction with an aggressive structural adjustment program helped trigger a long-sought-after economic recovery led by exports and the return of capital flows to Mexico. Moreover, by locating this stabilization-cum-liberalization strategy within a series of ongoing social pacts negotiated between the state, capital, and labor, PRI policy officials were able to project an image of greater public input and accountability.

    Hindsight shows, however, that beneath this veneer of concertación, the PRI was mainly up to its old tricks of securing political survival regardless of the potentially devastating economic costs. As Kessler argues, the maintenance of an overvalued exchange rate appealed to a broad domestic constituency composed of financial, industrial, and consumer interests. By containing inflation and the cost of mounting dollar-held debts, and by superficially pumping up consumer purchasing power, the prevailing macroeconomic strategy may have been unsustainable in the long run, but it did position the PRI for a political comeback after the beating it took in the 1988 presidential elections. Thus in terms of domestic politics, the refusal to adjust the exchange rate even though the 1993 year-end economic indicators had set red lights flashing can be partially blamed on the electoral cycle and the PRI's determination to prolong its seven decades of control over the Mexican presidency.

    But there were also new kinds of pressures on the international front that favored a fixed and overvalued exchange rate. Almost unwittingly, Mexico had become the test case for what David Hale calls the first "post-Cold War surge in securitized capital flows" to the developing countries since before World War I. International and personal investors, who held an unprecedented $34 billion in Mexican equities in 1994, were especially adamant in demanding that the Salinas team hold the line on the exchange rate. Furthermore, Washington viewed the U.S. trade surplus with Mexico in the early 1990s (largely a result of the strong peso) as a main selling point in favor of Mexico's entry into the North American Free Trade Agreement (NAFTA). The PRI used this combination of booming capital flows and the prospect of NAFTA entry, both of which were contingent on Mexico maintaining its macroeconomic status quo, to further bolster its political standing in the 1994 presidential elections.

    In the final analysis, despite the tenacity of Mexican policymakers in honoring their exchange rate commitment at home and abroad, the Salinas administration had, in fact, lost control of the macroeconomic fundamentals. Mexico's credibility plummeted as the PRI found itself wedged between the various domestic and international interests that it had so actively courted but could no longer please with a sinking currency. From the standpoint of exchange rate debates, it does appear that the shift to a more flexible regime after 1994 has enabled policymakers to better coordinate macroeconomic policy under much higher levels of trade and financial integration. Yet despite Mexico's impressive economic recovery, under way since 1996, Kessler notes that the PRI has in recent years faced greater levels of political contestation and electoral competition than ever before. This is because of the numerous multiplier effects from the peso crisis—a massive bailout of the domestic banking sector, ongoing allegations of PRI corruption, a relentless wave of urban crime, and an explosion in poverty rates. Ironically, although the PRI has long stalled in the implementation of political reforms that would allow for greater societal intermediation and public accountability, a main legacy of the 1994 crisis has been the ruling party's loss of political control and—as the 2000 presidential victory of National Action Party (PAN) candidate Vicente Fox confirms—the advent of more open politics in Mexico.

    Like Mexico, Brazil has landed on a path of exchange rate flexibility through no choice of its own. In both cases, policymakers were overwhelmed by the task of reconciling domestic political demands and international pressures in the context of an anchored exchange rate regime. By early 1999, Brazil's exchange rate was just one of many to come unhinged in the era of post-Cold War securitized capital flows. Thus Brazilian policymakers were certainly more aware than their Mexican counterparts had been of the dire global repercussions of slack macroeconomic policy management. This, unfortunately, did not mean that they were able to exert the necessary political control over economic policymaking. A main difference between the two cases was the more chaotic political backdrop that had prevailed over time in Brazil, where the conflicting and uncontrolled claims of various special interests had fueled high inflation and economic stagnation for more than a decade. This accounts for the cause of Brazil's January 1999 devaluation—chronically high fiscal deficits (see table 1-1)—in contrast to the Mexican crisis, which was triggered by reckless private sector spending and borrowing.


Excerpted from Exchange Rate Politics in Latin America by Carol Wise and Riordan Roett. Copyright © 2000 by The Brookings Institution Press. Excerpted by permission. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.

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Table of Contents

1 Introduction: Debates, Performance, and the Politics of Policy Choice 1
2 Exchange Rate Regimes and Policies: An Overview 23
3 The Mexican Peso Crash: Causes, Consequences, and Comeback 43
4 Brazil's Currency Crisis: The Shift from an Exchange Rate Anchor to a Flexible Regime 70
5 Argentina's Currency Board: The Ties That Bind? 93
6 Reform-Lagging States and the Question of Devaluation: Venezuela's Response to the Exogenous Shocks of 1997-98 123
7 The Politics of Exchange Rate Management in the 1990s 159
Contributors 169
Index 171
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