Trade regimes and exchange rate pass-through: Is there a Mexican enigma?

This paper examines the effect of trade regimes on exchange rate pass-through i.e, the relationship of import prices to the exchange rate. On the surface, empirical findings from Mexico contradict existing theory. Exchange rate pass-through was close to one in the presence of non-tariff-barriers when Mexico was a very closed economy, and dropped in 47/53 narrowly defined industries as import shares and commercial ties with the rest of the world increased. The solution to the puzzling behavior of pass-through lies on the market structure effects of Mexican NTBs, Import licenses prior to trade liberalization led to the creation of monopolistically behaving importers who found it optimal to fully "pass-on" exchange rate fluctuations. Therefore, what is commonly regarded as a quantitative restriction actually worked as a privately administered tariff, Trade liberalization eliminated monopolist importers causing prices of imports to fall as entry acid increased goods variety caused percived elasticities to rise. Thus pass-through appears to be low during this period. The six sectors in which pass-through did not fall, belonged to agriculture and paper which had state owned monopolis as the only entities allowed to import goods thereby fully corroborating the framework proposed for the closed period as well as food policies. Similarly, we find a positive and significant correlation of fall in pass-through and entry in the import sector confirming the post liberalization scenario. These findings suggest conventional protection measures understate the degree of trade liberalization for many structural reform programs. Moreover, we argue that a cointegration equation is the proper way to test for the law of one price which we find to hold between Mexican import prices and U.S. PPI.