Mexican Peso: You Haven’t Missed It!

3 May 2017

The Mexican peso has enjoyed a nice rebound in 2017 following its collapse in recent years.  With the Trump administration’s approach to its relationship with Mexico seemingly in a constant state of flux, investors are left to consider whether it is too late to buy the MXN or if this year’s bounce is a welcome opportunity to reduce risk.

Chart 1 highlights two key points.   In broad terms, a central prevailing objective of Mexican monetary policy in the past has been to maintain trade competitiveness by pursuing a stable exchange rate in real terms. That is, the nominal exchange rate reflects underlying fundamentals by fluctuating enough to offset the inflation differential with the United States.  However, the Chart reveals this relationship has broken down since 2014.  Indeed, the inflation-adjusted exchange rate is now cheaper than at any time since the 1994Tequila crisis!

What’s behind this altered policy and the peso’s extreme valuation?  In recent years, the Mexican economic performance has been imbalanced: relying too heavily on consumption benefiting from low interest rates and solid employment gains.  Meanwhile, exports have struggled.  As a consequence of this mismatch, Mexico’s current account deficit widened from 1% to 3% of GDP by 2016.

Fortunately, this pattern is changing now for the better.  Since last summer, Mexican exports have surged — benefiting from the synchronised upturn in the global economy.  Indeed, non-oil sales to the United States are at record highs, and exports to the rest of the world (which had been declining since 2012) are advancing strongly.  On the other hand, the consumer has felt the pinch from rising inflation caused by the peso’s collapse and this year’s hike in energy prices.  While overall GDP gains will remain modest, more balanced growth should shrink the current account deficit.

Under normal circumstances, Mexico would have little difficulty financing an external deficit of this size.  Indeed, Mexico has continued to attract around $30 billion in foreign direct investment inflows in both 2015/16 – enough to cover the current account shortfall.  However, foreign investors fled the Mexican government bond market:  becoming were net sellers of $15 billion in 2016 compared to purchasing $25bn in 2014.

The US Federal Reserve’s decision to begin the process of policy normalisation in December 2015 also contributed to the peso’s woes.  And, even though the Bank of Mexico also tightened monetary policy, markets questioned Mexico’s appetite for higher rates as inflation was running near the bottom of the targeted range at that time.  However, the Bank of Mexico has been more aggressive than the Fed, raising the overnight raise 350bp (compared to 75bp in USA).

And, with Mexican inflation now tracking well above its 3% target (5.4% in March), the central bank’s willingness to tighten further if needed to ensure inflation reaches its goal is less likely to be questioned.   The wider interest rate differential is likely to attract foreign investors again, which will allow Mexico to comfortably finance its current account shortfall.

Oil:  The Mexican peso is often viewed as a petro-currency – a view supported by the recent spike in the correlation between the exchange rate and the oil price during the latter’s collapse since 2014.  However, it is easy to forget that the correlation had fallen sharply during the mid-2000’s, reflecting the reduced role of oil in the economy.  Indeed, oil/GDP has fallen from 10% to 4% during the past 20 years. And, oil’s share in total exports has fallen to about 5% compared to 15% in 2012.  Nevertheless, the combination of both the sharply lower price and a dramatic decline in oil production accounted for the current account’s deterioration in recent years.  Indeed, this decline in oil output played a key role in Mexico’s decision to liberalise its energy market, opening it to foreign investment.

However, Mexico’s fiscal position remains dependent on black gold:  Indeed, as recently as 2012, 40% of government revenues came from this source.  Fortunately, the government’s fiscal reforms have succeeded in boosting non-oil revenues.  Indeed, despite the recent sharp decline in oil receipts, the budget deficit has not deteriorated.  Finding alternative budgetary revenues remains a priority as oil taxes will decline further, and the government will face numerous spending priorities in the future. The recent rise in government debt (to 55% of GDP from 38% in 2007) further emphasises the importance of these fiscal reforms.

To be sure, the peso will remain correlated with oil prices.  However, the recent spike in the correlation is not surprising given the intensity of the collapse in oil prices since 2014.  However, recent fiscal and energy reforms should further reduce Mexico’s dependence on oil.  And, if oil prices remain more stable in the period, the link should diminish again.

NAFTA:   The Elephant in the Room

Of course, President Trump’s hostile rhetoric regarding NAFTA (and the Wall) has contributed significantly to the peso’s travails; however, the President’s recently stated preference for renegotiation rather than withdrawal is encouraging.  While this topic is too complex to analyse in a short blog, I assume an updated, improved Agreement will eventually emerge for many reasons.

  • Start with the obvious, both sides have too much to lose. It is quite possible that Mexico has benefited more from NAFTA, and has more at stake (70% of exports head to  the USA and remittances total over 2% of GDP annually).  But, that is not the point. US exports to Mexico now represent 15% of sales abroad (and rising).  It is estimated that over 2 million US jobs depend directly upon trade with Mexico.  Likewise, US foreign direct investment into Mexico now totals nearly $100bn.
  • In addition to direct these direct commercial ties, the development of complex supply chains help improve US competiveness in third markets. For example, US imports from Mexico contain 40% of US content , which is much higher than 5% for Japan and    Also, roughly 30% of US imports from Mexico are eventually exported to third markets (as the US benefits from low Mexican wages along the supply chain).
  • While the Trump team’s focus on bilateral trade imbalances is misguided, Mexico is not a big problem. To be sure, the bilateral deficit is $63bn, but that is a fraction of the $230bn that the US exports to Mexico.  In comparison, the US-China deficit stands at $347bn, while US exports to China are only $115bn.
  • The US-Mexican relationship is multi-faceted, including cooperation on security and terrorism. Considerable progress has been made on immigration.  Indeed, net migration into the USA has been negative during the past 15 years (more Mexican returning home than arriving).  In addition, the number of illegal Mexican immigrants in the United States has fallen by over 1 million since 2007. Of the remaining 6 million unauthorised Mexican residents, nearly 80% have lived in the USA for over ten years.  The recent rise in the number of illegal Central American migrants to the USA coming through Mexico is now a more pressing issue, and the US will need continued Mexicans assistance to curb this influx (Wall or no Wall).
  • Most agree that updating NAFTA makes sense, and will create huge opportunities for US exporters. For example, liberalising service trade would boost US sales.  Currently, US service exports to Mexico represent only 11% of bilateral trade in goods and services between the two nations – well below the 33% average for all US trading partners.  Improved market access could easily add $20bn to US sales to Mexico.
  • Special protections for Mexico’s energy and telecom industries were part of the original NAFTA accord. Recent reforms will allow foreign investment and trade in Mexico’s energy sector.  Potentially, this could add up to $10bn to US exports in the near term.
  • The rejected Trans-Pacific Partnership (all three NAFTA members participated in the negotiations) updated and improved treatment of E-commerce, intellectual property rights, rules of origin, investments, customs and trade facilitation, dispute resolutions,  and labour and environmental protections .  Potentially, this would provide an already well developed foundation for an updated NAFTA plan for all these key issues.

Market Outlook:  More balance economic growth, pro-active Bank of Mexico monetary policy, successful Mexican fiscal (and other) reforms, and greater oil price stability support the outlook for the Mexican peso.  With the currency dramatically undervalued, the peso could rally sharply if NAFTA talks go well.  You have not missed it: the peso could reach MXN/$15 over the next 18 to 24 months.