Capital Flows and Macroeconomic Management: Tequila Lessons.

This paper examines the recent financial debacle in Mexico and its effects on other emerging markets (the Tequila effect). I argue that financial and liquidity considerations--as opposed to current account sustainability or real exchange rate considerations--appear to have played a prominent role. Special attention is given to financial factors in Latin America. On this basis it is concluded that Mexico and Argentina were particularly vulnerable to speculative attacks. For contrast, the experience of Austria is examined and compared with that of Mexico. The analysis suggests that the remarkable stability of Austria--which pegged its currency to the Deutsche Mark for more than 15 years--may be due to the low volatility of its monetary aggregates. I also argue that financial factors could account for multiple self-fulfilling equilibria, helping to explain the sudden and deep reversals in Mexico and Argentina. It concludes with a discussion on policy implications. I suggest that, aside from the usual fiscal prudence advice, countries should pay special attention to the banking system and the maturity of public debt. Furthermore, the appropriateness of an exchange rate regime should take into account the characteristics of the financial sector. [ABSTRACT FROM AUTHOR]