¿A dónde vas, peso?

The peso's recent strength is mainly due to market dynamics;
sooner or later it will return to normal levels.

By Deborah L. Riner, Chief economist at American Chamber/Mexico.

Brazil's forced devaluation of the real in January, sent the peso plummeting from 9.87 pesos per US$1 to 10.25 pesos in just one week. In previous attacks on the currency in some emerging market countries, investors fled the assets class, penalizing financial markets and the real economy in developing countries pretty much across the board. But the fall of the Brazilian "Maginot Line" did not have the disastrous international consequences anticipated, at least not in Mexico. Surprisingly, the peso quickly recovered from the Brazilian shock, appreciating to 9.96 pesos per dollar a month later. But the peso didn't stop there. In a gravity-defying show, the peso appreciated 4.6 percent in nominal terms in the next six weeks and another 2.3 percent in April. At 9.30 pesos, a dollar cost less than it had any time since the first half of August 1998.

In purchasing power parity (PPP) terms, the peso was overvalued by 10 to 15 percent in early May. Is this a serious problem? No, in AmCham's opinion. PPP calculations are just one of several ways to assess the appropriate value of a currency. Relative labor costs and supply and demand can also be used. In those terms, the peso wouldn't seem to be overvalued. Since the market price is what a floating exchange rate regime gives us, the peso is always correctly valued.

Neither are PPP calculations as precise as they appear. The year chosen as the "base" for calculating the inflation differentials can yield very different conclusions as to the present appropriate value of a currency. PPP calculations do not take into account differential changes in productivity. If productivity is increasing much more rapidly in a country than in its traditional partners, the productivity gains offset some of the inflation differential.

In Mexico, the odds are against further, significant jumps in productivity. Many larger companies and firms with foreign ownership expect productivity gains on the order of 5 percent per year.

The productivity gains we are seeing and are likely to see in Mexico are not significant enough to offset the inflation differential between Mexico and the United States. While rising productivity continues to be critical to the competitiveness of Mexican companies, it does not justify the real appreciation of the peso we've seen.

Even taking into account the shortcomings of PPP valuations, a peso overvalued by 10 to 15 percent in PPP terms is enough to cause concern. It points to an underlying change in relative cost structures that, over time, affect competitiveness, something markets do not necessarily reflect on a daily basis.

Market drive

If the gap between the rate at which the peso depreciates and the U.S.-Mexican inflation differential remains this wide for several years, an overvalued peso in PPP terms will cause difficulties for exporters and bestow a comparative advantage on importers. AmCham does not expect that to happen. In a floating exchange rate regime, the exchange rate can be temporarily out of line with the underlying fundamentals of the economy, but it is extremely unlikely a serious misalignment will persist over a period of years. Sooner or later, the peso will depreciate.

The question is when, by how much, and what will trigger the weakening of the peso. What will prompt the peso to move, and when that will happen, is hard to say. Bad news on the growth or stock market front in the US would certainly do it. As preoccupation over the strength of the peso grows, any pretext will do. Political developments here or a larger than expected trade amount deficit could spark a bigger demand for dollars.

Experience suggests that most of this year's depreciation will come between August and November. Since the floating exchange rate regime was introduced in 1995, the peso has devalued significantly more in those four months than in the prior four months, April-July (see table). In each of the last four years, the peso has depreciated minimally or appreciated in the first four-month period. In the second period each year, the peso has always depreciated.

Inflation doesn't explain the differing rates of slippage. The seasonal behavior of the trade account does. Typically, the trade account deficit in the third and four quarters accounts for almost 60 percent of the annual deficit. The peso revalues in December, helped by the fact that a disproportionate amount of what shows up as "net transfers" in the current account are remitted in December by Mexicans working abroad.

Indicator force

This year, the seasonal decline in the demand for dollars in the first quarter was accentuated by the slowdown in economic activity. In April, the skyrocketing Mexican Stock Exchange (BMV) left no doubt that Mexican equities continued to attract foreign investment (see box below for an analysis of foreign investment in equities.) Mexican entities, both public and private, have been well-received in the international debt markets. In the first four months of the year, the public sector has placed US$5 billion in debt in foreign markets. In the last half of April, bankers expect that creditworthy private names will have no difficulty raising funds in the international markets.

The combination of lower demand and greater supply had the predictable effect: the price - in this case, of the dollar - fell. The recovery of the economy will boost demand for dollars. The recovery of oil prices will add to the supply of dollars. It may also allow government spending in the last half of the year to expand while respecting the 1.25 percent GDP fiscal deficit target: higher oil prices will produce the additional revenue that will keep the fiscal deficit under control. If government expenditures are greater than programmed, more rapid growth would further boost the demand for dollars. AmCham expects the demand for dollars to grow more quickly than the supply, pushing the peso to $10.55 by the end of the year.

It's not any easier to say by how much the peso will slide when it does fall than to pinpoint the date or the cause of the adjustment. The nature of the beast in a floating exchange rate regime is that adjustments tend to be abrupt and disproportional. The longer the move to a weaker peso is delayed, the larger it is likely to be.

The strength of the peso is both surprising and of concern. That it is of concern will eventually prompt it to devalue. For the strength of the peso to seriously harm exports, the peso would have to remain this strong for more than a few months. The government is not propping up the peso for its own political ends. Were it to try, the floating exchange rate regime, coupled with the information now available, makes impossible a repeat of 1994 when the government spent some US$18 billion of reserves in an ultimately futile effort to sustain the parity.

RATES OF SLIPPAGE Peso and Inflation Trends 1995 - 1998
YEAR	PERIOD: April-July		PERIOD: August-November
	Devaluation /Inflation	Appreciation	Devaluation /Inflation	Appreciation
1995	10.3%	18.4%	-19.8%	8.5%
1996	-0.7%	7.9%	-3.5%	5.8%
1997	1.0%	3.8%	-5.0%	4.1%
1998	-3.7%	3.9%	-10.2%	5.9%

Bolsa rallies

BMV statistics (adjusted for the change in the value of existing holdings using the BMV index as a proxy) suggest that foreign investment in equities rose in both February and March. The methodology has indicated an inflow in only three of the last eleven months. Two of those three were in the first quarter of this year. The ongoing boom of the BMV in April (9.82 percent in pesos in the month, a 36.74 percent gain in the first four months of the year) suggests the inflows continue in the fourth month of 1999.

Foreign investment in the Bolsa (unadjusted) has been rising as a percentage of market capitalization since it first became a significant factor in the Mexican equity market. In 1990, foreign investment accounted for 10 percent of market capitalization. In 1994 and 1995, it represented over 26 percent of market capitalization. Its share continued to rise in this presidential term: foreign investment represented 29 percent of market capitalization at the end of 1996, 31.3 percent at the end of 1997, 35.4 percent last year, and 37.1 percent on March 31.

In five of the seven months up through March 1999, foreign investment in government money market obligations fell. It did not rise in two consecutive months. On March 26, the latest data available at the time of writing, foreign investment in government money market obligations was US$62 million less than the US$2.34 billion invested at year-end 1998 and 36 percent less than it was on August 31, its 1998 month-end high. Foreign investment in government money market obligations, at the end of March, was more than 30 percent below its year-end levels in 1995, 1996 and 1997. Clearly, the most volatile form of foreign investment no longer represents a serious threat to a US$450 billion plus economy.

Caja

Foreign investment in equities (In millions USD)
	1997	1/98	2/98	3/98	4/98	5/98	6/98	7/98	8/98
Total	$1.0	$0.9	-$0.9	$2.3	-$1.1	-$1.9	-$0.2	-$0.2	-$2.2
Free Subscription shares	$1.7	$0.3	-$0.6	$0.8	$0.8	-$1.5	-$0.7	-$0.1	-$1.4
ADRs	$2.3	$0.4	-$0.6	$1.4	-$0.9	-$1.8	-$1.0	-$0.3	-$1.6
	9/98	10/98	11/98	12/98	1998	1/99	2/99	3/99
Total	-$1.2	-$0.7	$1.9	-$2.4	-$5.7	-$0.6	$0.6	$1.5
Free Subscription shares	-$0.8	-$0.4	$0.7	-$0.6	-$3.4	-$0.6	$0.3	$1.0
ADRs	-$1.0	-$0.6	$1.1	-$0.5	-$5.4	-$0.8	$0.4	$1.3

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