MEXICO: Peso pressures

Tuesday August 19

The Bank of Mexico (Banxico) on August 16 increased its benchmark interest rate by 25 basis points to 8.25%.  The tightening -- the third in as many months -- was widely expected.  However, it increases the interest rate differential with the United States. This may increase pressures on the peso to appreciate further, particularly since the currency is increasingly attractive to short-term investors.

Policy divergence. With a solid financial system and an economy that is slowing but far from recession, Banxico has been able to concentrate on curbing inflation. US monetary authorities, by contrast, have been forced to slash interest rates and may keep them at extremely low levels. The interest rate differential has widened from 75 basis points in April 2007 to 600 today.

Attractive peso. The significant interest rate differential has increased greatly the peso's attractiveness for those engaging in 'carry trades'. Inflows of capital that bet it will remain stable or appreciate, at a time when debt instruments denominated in local currency pay much higher interest than those denominated in dollars or other currencies, may create further appreciation pressures.

Moreover, Banxico is well known to be extremely reticent to intervene in exchange markets. The peso for years has floated cleanly, with the central bank arguing that it targets inflation, not the exchange rate. Therefore, re-emergence is possible of the ''superpeso' -- as it was known in 2001-02.

Welcome strength? The central bank in the short term may welcome a strong peso, given significantly rising inflation and inflationary expectations in recent months:

• A robust currency would help keep in check domestic prices, through cheaper imports.

• Peso strength is unlikely to exacerbate the current account deficit, which is expected to fall substantially due to economic slowdown.

However, there is a danger that a strong peso, combined with sharp US economic slowdown, may affect negatively manufacturing exports, as happened from mid-2001 to 2003.  The most recent figures, to June, indicate that export growth has continued unabated. Any significant decline or reversal would elicit a strong reaction both from exporters and the Calderon administration.

Banxico is determined to arrest any significant increase in inflation and has strengthened its credibility with recent interest rate rises and revised 2008-10 projections. However, the significant Mexico-US interest rate differential may place unwelcome upward pressures on the peso, which already is touching six-year highs. The central bank will face pressures to loosen if exports decline significantly, particularly in the manufacturing sector.