After Citigroup?s recent announcement that it is buying Banamex, Mexico?s second largest bank, the peso rose sharply.  This is the first time since June of 1998 that it has traded below 9 pesos per dollar, and is the latest development in the peso?s remarkable strength over the last two and one-half years.  The peso has been stable in foreign exchange markets ever since the Asian crisis of 1997-1998 spilled over into Latin America and caused it to fall in mid-1998.

A strong currency benefits an economy in a number of ways, but it also has its downside.  Currency stability coupled with inflation that is higher in Mexico than in the United States causes an appreciation of the peso in real terms, once an adjustment is made for inflation differences.  Real appreciation is good for consumers and importers, but it hits exporters in the pocketbook, and reduces the competitive advantage of Mexican firms.  Consequently, the relatively strong peso has generated concerns about its future value and heightened expectations that a sharp depreciation may be forthcoming.  Is the peso overvalued?  If so, how much, and is a collapse around the corner?

This issue of the Cross Border Economic Bulletin looks at recent trends in the Mexican economy that are relevant to the future course of the peso.  While it is impossible to predict future exchange rate changes, it is possible to look for the warning signs of an approaching storm.  The main conclusions of this month?s bulletin are:

? By most conventional measures, the peso is probably overvalued;

? Key indicators of potential problems?the size of the trade deficit and the stock of international reserves?appear healthy;

? Export industries and foreign investors in export industries would benefit from a moderate depreciation, but

? Depreciation hurts consumers and undermines the government?s ability to reach its inflation targets;

? There is always a possibility for surprises?both good and bad?but a sharp depreciation such as occurred in 1994-1995 seems highly unlikely.

The peso is overvalued

P E S O S	Figure 1: Pesos per Dollar

Mexico?s peso has been relatively stable since mid-1998 when the turmoil from Asia spilled over into a number of other emerging markets.  While the Mexican economy was hurt less than Russia and Brazil, the peso suffered a mild speculative attack.  Figure 1 illustrates the peso?s movements by showing the average monthly exchange rate with the dollar, measured as pesos per dollar.  An increase is a peso depreciation, while a decrease is an appreciation.

Between June and October of 1998, the peso lost about 16% of its value, but since then, it has held steady.  An unchanging exchange rate has many advantages, but one issue of concern is that Mexico?s inflation, which has been about 10% more than the United States?, has led to a real appreciation of the peso and is making exporters less competitive.

The reason that higher inflation causes real appreciation is straightforward.  Since late 1998, Mexico has experienced average annual inflation in consumer prices of around 13-14% (although it has fallen to under 8% lately), while the United States, its main trading partner, has averaged around 3-4% inflation per year.  Consequently, the peso lost purchasing power inside Mexico at the rate of 13-14% per year over the last two and one-half years, while it lost purchasing power in the United States at the same rate as the dollar?3-4% per year?since it held steady against the dollar.  The net change makes goods purchased in the United States about 10% cheaper per year, relative to their cost in Mexico.

Figure 2 plots the change in the real value of the peso.  In Figure 2, an upward trend is a strengthening peso.

Index, 1990 = 100	Figure 2: The Real Value of the Peso

Since late 1998, the peso has gone from an index of its value equal to 100 to around 125, representing a 25% gain in real terms against the dollar and the currencies of its other trading partners.  Around 5% of the gain in value was a recovery of the value it lost in the wake of the Asian crisis, but the remaining 20% reflects a real increase since late 1998.

A strong peso is good for Mexican consumers and importers but bad for tourists and exporters.  Consider, for example, a maquila that sells its output in the United States. Its revenues are in dollars, but labor and other local input costs are in pesos.  If Mexican labor and local inputs are around 20% of total costs, a 25% rise in the real value of the peso adds around 5% (0.20 x 0.25) to total costs when measured in dollar terms.  The 5% is a rough figure, but it would underestimate the situation for non-maquila exporters since they derive a larger share of their inputs from the local market and do not pay executives in dollars.

Millions $US	Figure 3: Mexico’s Monthly Trade Balance

Few signals for a sharp depreciation

Overvalued currencies are one of the primary causes of financial crises, and given the devastating recession that hit Mexico in 1995 after the last peso collapse, it is not surprising that there is some nervousness over the peso?s appreciation.  Nevertheless, the other signs of a looming crisis are either very weak or entirely absent.  This is no guarantee against a disorderly and chaotic correction, but a peso collapse such as the one that occurred in late 1994 and early 1995 is highly unlikely.

First, an overvalued exchange rate usually results in large and growing trade deficits as exports become less competitive and imports become cheaper.  In Mexico?s case, this has not happened.  Figure 3 shows the trade balance.

Since early 1998, there has been a weak trend towards an increasing trade deficit at the rate of approximately $US6 million per month.  Mexican imports, however, remain strongly biased towards intermediate and capital goods, with consumer goods making up only 10-12% of total imports.  Hence, the trade deficit reflects an expanding economy in which producers are bringing in capital equipment and intermediate inputs.  The broadest measure of Mexico?s commercial balances with the rest of the world, the current account deficit, was equal to approximately 3% of Mexico?s GDP in 2000.  Forecasts are that it will be 3-4% of GDP in 2001.  This is smaller than the U.S. current account deficit, although Mexico is ultimately more vulnerable than the U.S. because its currency is not widely used in trade, nor is it a safe haven for individuals and firms outside the country.

In 1994, Mexico?s trade deficit was much larger, both absolutely and relative to the size of its GDP.  In addition, there were several complicating factors: two high-profile political assassinations (the PRI presidential candidate Donaldo Colosio and the Secretary General of the PRI), the onset of the Chiapas rebellion, rising interest rates in the United States, increasing federal deficits and growing short-term external debt, and the presidential election of August, 1994.  Mexico?s large and rising trade deficit became a problem because investors inside and outside Mexico viewed the government?s assurances of no devaluation as inconsistent with the underlying realities and uncertainties of the Mexican economy.  Consequently, throughout 1994, domestic and foreign investors were looking to avoid losses by taking large quantities of their assets out of Mexico.

A crisis is often triggered when the capital that is fleeing a country causes the central bank to run out of foreign reserves.  In 1994, reserves disappeared at an alarming rate and by mid-December, 1994, the government could no longer convert pesos to dollars at the fixed exchange rate, forcing an eventual adoption of a floating rate.  The changes in international reserves are shown in Figure 4.

Millions of $US	Figure 4: Quarterly Changes in Mexico’s Net Reserves

Capital flight in 1994 is shown by the two troughs in that year, one in the first quarter, the other in the fourth quarter.  To date, Mexico has continued to accumulate reserves over the last several years.  Currently (May 11, 2001), the government holds $US 38.6 billion (thousand million) in reserves, more than any Latin American country.

Summing up

The trade deficit is large but manageable, and the level of international reserves is quite good.  In addition, Mexico?s economic fundamentals are very solid by comparison to 1994.  The banking sector is in much better shape than a few years ago and, perhaps most importantly, the country has adopted a floating exchange rate system so that they are no longer obligated to convert pesos into dollars at a set rate.  In addition, recent fiscal reforms have put in place controls over the government?s budget so that it will remain balanced or nearly so.

The challenges to Mexico?s policymakers remain as intense as ever, and it is always possible that an ugly surprise such as political violence might suddenly appear, but the fundamentals of Mexico?s financial system appear strong.  Strong fundamentals coupled with its growing ability to export manufactured goods give the economy more flexibility and greater resilience than at any time in recent history.  Predicting the future course of a currency is nearly impossible, but judging by current conditions, there are no major storms around the corner.

The Cross-Border Economic Bulletin is prepared monthly by Dr. Jim Gerber, professor of economics at San Diego State University. It is underwritten by Concert, a global venture of AT&T and BT.