If you were following the global markets in the 1990s, you must have heard of the Tequila Crises. Mexico faced political shocks in 1994, including a rebellion in the southern province of Chiapas only few months before presidential elections; followed by the assassination of the ruling party's presidential candidate, Luis Donaldo ColosioIn; thereafter, interest rates increased significantly, while the peso went down the slippery slope.
At the time, the majority of Mexico's government debt was in the form of cetes, (short-term bonds equivalent to U.S. Treasury bills) that were sold on a regular basis. Following the shock of Colosio's assassination, interest rate on the 28 days cetes reached 15 to 16%, compared with 9.5% three month earlier.
So let me explain the currency and monetary policy consequences
In the early 1990s, the U.S. inflation was averaging 3% per annum, while Mexico's was hovering around 18%, at the same time, the Mexican peso was nominally deprecating against the U.S. dollar at approximately 5% per annum (i.e. Mexico's real exchange rate was appreciating at, give or take, 10% per year)
What was the implication of that scenario?
The 5% nominal depreciation was whipping 10% of the 15% inflation gap; on the other hand, Mexican goods continued to become more expensive relative to U.S. goods (U.S. was and still Mexico's largest trading partner)
Fixed Exchange Rate Policy
Many major exporting countries or countries with high trading partner concentration pursue a fixed exchange rate system, pegging their currency to either a basket of currencies of the trading partners (e.g. Singapore) or to the currency of that major trading partner, with the objective of reducing FX related trade risk to stabilize trade flow. In the case of Mexico, the policy was to peg the peso to the U.S. dollar since the U.S. market was Mexico's major export market.
What was the implication to Mexico for having a USD pegged peso?
Facing a fixed exchange rate system, the Mexican central bank lost its monetary autonomy. It had to follow the U.S. Fed's action regardless of Mexico's economic situation (e.g. raise rates when the economy is contracting and reduce it when the economy is overheating - basically the opposite of common sense).
Mexico faced inflation deferential with that of the U.S., depreciating nominal exchange rate and changing (increasing) real exchange rate, leading to a failure in relative Purchase Power Parity (NYSE:PPP).
The problem was amplified by the fact that the majority of Mexico's capital inflows back then was in the form of portfolio inflows rather than more permanent Foreign Direct Investments (NYSE:FDI). The investor base (i.e. providers of portfolio inflows) understood Mexico's dire need to eventually depreciate the nominal exchange rate and since their investment was in the form of portfolio inflows, it was relatively easy for them to sell and run-off.
How did the Mexican Central Bank Respond?
The Mexican Central Bank had to raise interest rate to defend its currency, but since its monetary policy had to mirror that of the U.S Fed (remember the EMS crises), it responded by buying pesos and selling dollars, draining its FX reserves and shrinking its bank balance sheet, which was essentially the Central Bank's tool to raise interest rates.
Where the Mexican economy stands today?
Mexico has since abandoned its fixed exchange rate policy. Its external sector, however, continues to be tied to the US economy, which accounts for almost 80% of Mexico's total exports, but declining from a peak of more than 90% in the late 1990s.
Now, as an independent monetary body, the Mexican Central Bank succeeded in gradually reaching its target inflation rate of 3%, give or take, versus the double-digit inflation rate of the 80s and the 90s. Strong economic fundamentals and a surge in productivity led to downward pressure to consumer prices.
As for the peso, now a freely floating fully convertible currency, it's now predominately trading according to fundamentals, becoming one of the most liquid global currencies (Spot liquidity: Average daily volume of USD 7 billion and Spot Average bid/offer of 25 pips). Nonetheless, the peso faces some external volatility, given that its ample liquidity makes it a short-term proxy hedge for broader emerging market risk.
As for fiscal policies, in 2013 Mexico debt stood at less than 40% of GDP with fiscal deficit at -2.4% of GDP. In addition, Mexico's short-term debt as % of total external debt averaged around 20% over the past 4 years compared to 37% in 1994, reducing the country's exposure to roll-over risk and currency risk.
In addition; in 2013, current account deficit stood at $22 billion (less than 2% of GDP), while in terms of FDI, Mexico received $37billion of inflows.
Mexico, however, has one of the lowest Latin America's credit penetration, with penetration rates standing at 18% of GDP in 2013, compared to Chile's 79% and Brazil's 57% penetrations. Credit growth has been very moderate, slightly higher than real GDP growth, driven mostly by the high informal labor rates. The low credit penetration had a large impact on the growth of microfinance in Mexico.
Initiated by the prior Mexican administration led by former President Felipe Calderon, major reforms have been considered to be powerful forces in the Mexican growth story. Starting by the labor reforms aimed at providing hiring/firing flexibility and increasing productivity (low labor productive has always been a major determent to Mexico's economic growth story). The current President - President Enrique Pena Nieto has also championed multi-industry reforms:
Ø Telecom reform that allows for 100% FDI inflow for telecom and 49% for Media; the approved changes also include a definition of a dominant player, limiting market share to 50% . One of the objectives of the law is to increase the Mexican mobile market penetration, which is the lowest in Latin America, standing at 86% vs. 130% in Chile and 121% in Mexico
Ø Financial reform aimed at increasing credit penetration by establishing stronger legal framework that reduces the high cost of enforcing contracts in Mexico (the cost of enforcement in Mexico is 37% of the legal claim compared to 16% in Brazil and 14% in the United States). The financial reform would allow the transferability of claims across financial institutions, create a single credit scoring bureau and would slash the costs associated with bankruptcy processes
Ø Education reform that allows for a transparent teachers evaluations by using standardized publically available evaluation metrics
Ø Energy reform that would limit Pemex's priority of participation over private participants in new oil fields bidding rounds to its technical capabilities; the reform would give a priority to Pemex, but also force it to improve its technical capabilities such as mapping technology and productivity, maximizing the company's long-term value to Mexico; the reform also eliminates the Mexican States exclusivity of electricity generation and gives the States the autonomy to outsource transmission and distribution to private contractors.
In addition, Mexico would stand to benefit from the Re-industrialization of Latin America as more and more companies adopting near-shoring value-chain strategies given the increase in China's labor cost.
How to Trade on the back of the Mexican growth story in the medium term?
· Cemex: The giant home builder would benefit from the expected turnaround in Mexico's construction and infrastructure spending, both within the public and the private sectors
· MXN: Despite the strong economic outlook, the peso, as an emerging market hedging tool, sells off in periods of sharp declines in emerging markets driven by the U.S. Fed decision to taper/end its QE program. Investors should consider building positions in MXN in those periods of sharp reversals