Recent events in Mexico have prompted some to liken the current situation to the 1994 Tequila Crisis which ended with hyper-inflation, a collapse of the Mexican Peso, emergency loans from the US to the Mexican Government, and a deep economic contraction. The Financial Times even ran a story saying that the US, Mexico and the IMF should pre-negotiate terms of an assistance package in case it is needed. (Though to be fair, they admitted such a case is highly unlikely) Many of these voices come from the fact that two factors which proceeded the '94 crisis are superficially present today. Namely, '94 was a year of political instability in Mexico and the beginning of a monetary tightening cycle in the US. It is true that street protests are happening in Mexico over the murder of 43 students in Igula, Mexico, and the Fed will probably hike rates next year. However, noting a few similarities and concluding that Mexico is on the brink is shoddy analysis. Mexico has worked had for twenty years to learn from the '94 crisis and shore up its defenses so that it can absorb both internal and external shocks.
In 1994, Mexico was on a fixed exchange rate regime. Thus, any exit of dollars out of the country would force the Bank of Mexico to sell dollar reserves to defend the peg. This made it extremely attractive for speculators to attempt to break the peso on the hint of any sort of trouble. When a presidential candidate was assassinated in '94, and the Fed was on the verge of raising interest rates, which would increase the incentive for US investors to repatriate funds from abroad, a perfect storm ensued and the rest in history. The pre-election spending spree by the Salinas administration also caused some to worry about the government's fiscal position, and began to scare off international investors.
Today the Bank of Mexico has over 190 billion USD in reserves and is committed to flexible exchange rate. It has the most liquid capital markets among the EM countries, with government yield curve going out to 30 years. Government finances are stable and the Mexican Government has no problem funding itself exclusively on the MXN denominated local market. Thus unlike '94, it does not depend on external financing, a significant fact given that international investors are more easily spooked by bad news. Mexico also has a 71 billion dollar flexible credit line(which was renewed this month) with the IMF which serves as a further buffer.
Central bank independence, which was an initial reform implemented in the wake of the '94 crisis, has served Mexico well. Since then, inflation targeting from the Bank of Mexico has delivered price stability as well as a strong, strictly regulated and well capitalized banking sector. 2014 is not a replay of 1994.
The selloff in recent weeks, and especially since Thanksgiving, has been the product of many factors. First, oil prices have plunged since OPEC announced that it would maintain production despite the current oversupply. This has caused some to worry about the Mexican economy, given that Mexico is major oil producer. However, it is important to note that today crude oil accounts for only 10 percent of Mexican exports, as compared to over fifty percent in '94. Mexico has done a remarkable job diversifying its industrial base. A report release on Friday showed that manufacturing output increased by 3.9 percent. Construction, which had been in a terrible slump since mid 2012, surged 5.4 percent, the fourth consecutive month of gains after nearly 18 months of contraction. In sum, both internal and external demand appear to be rebounding. Yes, Mexico will earn less from its oil, but that is but a small component of a highly diversified economy.
Secondly, a broader EM sell off has occurred on prospect of tighter US monetary policy. This was exacerbated by the Dec 5th non-farm payrolls report which beat expectations by over 100,000 jobs. Unlike prior episodes, Mexico was unable to escape as the USD strengthened broadly.
Third, the MXN got hit again by risk-off sentiment last week as concerns over global growth pushed bond yields down. The usual safe haven suspects rallied, (CHF,JPY) and EM currencies were on the back foot again regardless of idiosyncratic strengths or weaknesses. It was just more panic selling.
Fourth, the Mexican peso is the most liquid of the EM currencies and is the 8th most traded currency in the world. Many speculators have made large bets against the peso as a 'proxy' in order to profit from the broader EM selloff. This exaggerates the Peso's downward moves at times. Unfortunately, futures and options contracts do not exist for many other EM currencies, or are illiquid. This has encouraged many speculators to simply bet against the peso instead of betting against EM assets more broadly. This explains some extreme positioning the options and futures markets, with speculators amassing a record net short position against the peso.
Fifth, it is crucial to note that the Peso depreciation does not appear to be the result of capital flight. Indeed, participation by foreigners in the local bond markets is steady at 37 percent. More evidence that the trouble is coming from offshore speculators in the futures and options markets.
I will admit it. The last few weeks have been extremely humbling to say the least. The extreme positioning has caused a precipitous drop in the MXN. Oil linked currencies, such as CAD, NOK, and RUB have also sold off broadly as oil plunged The MXN, which in 2013 was able to resist the steep declines seen in the likes of ZAR, TRY, or BRL has had no such luck in Q4 of 2014. However, the firm rejection of the 15 level for USD/MXN may be a sign the there is finally a marginal bidder for the beleaguered peso. One strong piece of evidence in support of this view is that despite oil's 4 percent drop on Friday, the Peso held on to most of its gains, and was actually able to close the trading day up after falling as far as 14.94 to the dollar. While further long dollar positioning ahead of next week's FOMC meeting may crimp the Peso style, I expect the MXN recover broadly in the coming months. Q1 of 2015 should see a test of the 14 handle, and to end Q1 between 14 and 14.2. I expect to see USD/MXN ending 2015 between 13.50 and 14.
No comments:
Post a Comment