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By Eduardo Suarez Director and Co-Head, LatAm FIC Strategy Scotiabank |
The Mexican peso’s (MXN) poor performance is one of the topics we find ourselves most frequently discussing with our clients at Scotiabank. Sometimes, the peso is seen as an appetite-proxy for emerging markets (EMs), or LatAm, due to its liquidity. Other times it is just a proxy hedge for whatever risk seems prevalent at the moment – be it LatAm, or not. This peso-split-personality is frustrating for a lot of our clients. First, there has been puzzlement over the short lifespan of the “Mexico Moment”, where we saw a very short-lived flash of optimism drive steady appreciation in the first half of 2013, but which rapidly evaporated. After that, there has been constant discussion about what makes the peso a perennial underachiever (see chart below), including the tendency for MXN to be beaten up whenever a risk arises anywhere in the world – whether there seems to be a realistic link between the shock and the Mexican economy or not. Finally, there is the debate of whether authorities should do more, or less, to stabilize the MXN.
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The debate over whether Mexican fundamentals explain the peso’s weakness is a complex one, and not the focus of this piece, but we will just highlight a few points:
1) Mexico’s balance-of-payments position has weakened less, and looks stronger than that of countries with currencies that have outperformed it over the past year (including Brazil and Colombia);
2) Mexico’s fiscal stance has weakened, but the size of its debt and its primary balance (i.e. the pace of deterioration) are in line with credit rating peers (see the two charts below);
3) On the growth front, Mexico again looks fine, if unspectacular (it has been growing around 2.5%) and the peso’s performance has been worse than currencies of much slower growing economies; and
4) Mexico’s inflation is arguably the only one in LatAm that looks well controlled, and economic literature suggests there is a strong link between FX performance and inflation. Thus, we don’t think fundamentals are the primary driver of MXN weakness.
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If the peso’s poor performance is not fundamentally driven, then what drives it? We believe the peso’s underperformance is the result of market characteristics:
1) The peso tends to develop a strong correlation with whatever asset happens to be the focus of heightened market anxiety. For example, next to the pound, the peso was one of the hardest hit currencies by the Brexit crisis despite having the smallest trade links with the UK among major LatAm economies;
2) The peso is the most liquid EMFX according to the 2013 BIS Triennial survey, and is among the only EM assets that trades 24 hours; and
3) Thanks to Banxico’s credibility, and the liquidity of local fixed-income markets, local yields are low – boosting the peso’s attractiveness as a hedge. We think the peso’s fairly deep liquidity among EMFX and low carry mean that it’s a good hedge to use against other “longs” in risk-on periods, but also a good hedge to put on during shocks. After having seen the type of volatility that MXN has had over recent years, it is possible that other LatAm countries will think twice about taking steps towards liberalizing their economies to capital flows, and making their currencies easier to trade.
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Should Mexican authorities become more active volatility suppressors in the MXN market, and other countries avoid freeing their exchange rates? We don’t think so. Even though in the short run, it may be tempting to step in the way of volatility, in the long run we think this is a bad idea as long as volatility does not reach levels that generate broad stability risks.
In the long run, we think the best way to reduce the volatility created by shocks is to develop deep and liquid markets which have the capacity to absorb large flows consistently, as well as sophisticated risk management that limits “panic selling”. Deep and liquid FX markets result from clear and consistent rules, as well as easy access to a market. Unpredictable interventions go against this, as does making it harder to trade an asset.
In addition, to promote the development of more sophisticated risk management, an incentive has to be there – this incentive is called volatility, which makes suppressing it a bit short-sighted.
In an ideal world, MXN’s transition into a widely traded global currency would have taken place simultaneously with other major EM currencies. This would have allowed a sharing of the peso’s growing pains. However, the absence of other EMs taking the “next step” should not be seen as a reason to avoid taking it.
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