Mexico's Economic Stewards Take Market By Surprise



Monetary and fiscal measures tighten financial conditions, but the short-term pain bolsters sound economic fundamentals longer-term.

Over the last five years, the alphabet soup of monetary policy abbreviations has expanded meaningfully, with terms like NIRP (Negative Interest Rate Policy), ZIRP (Zero Interest Rate Policy) and QE (Quantitative Easing) entering the lexicon of investors. With the expansion of unorthodox monetary policy, one may wonder whether central bank moves globally still have the ability to surprise investors. Well, Banco de Mexico (commonly known as Banxico) certainly took the market by surprise. In a bold and coordinated move, Banxico and Mexico's Ministry of Finance announced a series of efforts aimed at stabilizing the recent slide in the Mexican peso. The initiatives include:

  • Hiking the policy rate by 50 basis points to 3.75%
  • Suspending the automatic U.S. dollar sales program with a preference toward discretionary intervention
  • Spending cuts totaling 132.3 billion pesos ($7.2 billion), or 0.7% of gross domestic product (GDP), on top of the spending cuts incorporated in the 2016 budget

Why did Banxico raise its key interest rate at an unscheduled policy meeting and change its currency intervention program?

It is important to understand their potential motives, it is important to examine the changes in the fiscal and external accounts that have occurred in Mexico over the last two years, both a result of changing external and internal dynamics. On the fiscal front, Mexico's deficit increased to 3.5% in 2015 from 2.3% in 2013, and the fiscal deficit is expected to hit 3.5% of GDP again this year. While the overall fiscal deficit remains under control compared to more troubled emerging markets such as Brazil (-8.2% of GDP in 2015), South Africa (-4.7% of GDP) and Egypt (-11% of GDP), the trajectory of the deficit is nonetheless concerning. Unfortunately for Mexico, the decline in global oil prices has impacted the revenues the government receives from Petroleos Mexicanos, the state-controlled oil company more commonly known as PEMEX. This has forced the government to respond via fiscal consolidation. On the external side, Mexico's current account deficit remains relatively benign at 2% of GDP. However, Mexico faces two problems: 1. It has a large errors & omissions account (think about this as the residual of the current account deficit); 2. The prospects for foreign direct investment in Mexico post the energy sector deregulation have been impacted by the ongoing collapse in crude prices. In simple terms, both of these issues mean the demand for Mexican pesos has been negatively impacted over the last two years.

So what does this mean for Mexico?

Since the beginning of 2014, the Mexican peso has depreciated a total of 29% versus the dollar. The peso's depreciation cannot be viewed in isolation: the Brazilian real is down 52% in that time frame; the South African rand is down 34%; and the Turkish lira is down 27%. However, the peso's decline has been greater than many economists would have predicted. Over the last five years, Mexico has been considered by many institutional investors as a blueprint for sound macroeconomic management. In 2013, President Enrique Pena Nieto instituted a series of constitutional reforms designed to modernize the country, including opening the energy industry to foreign competitors; financial system reform; education reform; telecommunications reform; among others. Foreign investors have since rewarded Mexico with strong capital inflows, including a high ownership of Mexican bonds. If we look at the cost of borrowing for the Mexican government, the 10-year Mexican bond recently yielded 6.13%, contrasting markedly with yields of equivalent sovereign tenures of 15.9% in Brazil; 9.2% in South Africa; and 10.6% in Turkey. Essentially, the Mexican government has been able to fund itself at significantly more attractive rates than emerging market peers. Mexico's public sector external debt amounted to a quite manageable $161.6 billion, or 15% of GDP last year. Nonetheless, the peso's depreciation prompted the central bank to draw a line in the sand: In its Feb. 17 announcement, Banxico specifically noted that its actions were aimed at ensuring the peso's value is "anchored" to the country's economic fundamentals. Supporting the currency no doubt also reflects concerns about the risk of foreign investors liquidating some of their Mexican bond holdings due to peso volatility.

Banxico also noted that the recent depreciation pressure on the peso "increased the probability" of higher inflation expectations that wouldn't be in line with targeted inflation. The action certainly looks preemptive, as the most recent data do not show this: the January consumer price index rose 2.6% year-over-year, well below the 4.4% rate exhibited in January of 2014.

There are risks:

By suspending the preset dollar auctions and moving toward discretionary intervention, Banxico is signaling to the markets its willingness to defend the peso whenever it feels the decline in the currency is greater than that warranted by economic fundamentals. Mexican reserves peaked at close to $200 billion in early 2014, and have since declined to $174 billion. It is quite likely that Banxico will need to use some of the reserves to defend the peso going forward, especially if global volatility remains high. This potentially opens the door to speculative attacks on the currency.

Our Take:

On the margin, we view the move by Banxico and the finance ministry as positive. While the Mexican peso could certainly continue to slide as a result of global macro trends, the measures taken by both Banxico and the finance ministry show a willingness to stick to sound macroeconomic management, even if that means tighter financial conditions in the domestic economy. Over the long-run, this ensures Mexico's economic fundamentals remain sound, with issues like debt sustainability and inflation management remaining under control. It should reinforce the view that Mexican authorities are responsible economic stewards.

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