The Surprising Peso

In the United States, most of us don’t worry about currency crises. Politicians rarely talk about the stability of the dollar because it is a world currency. Global demand keeps its value relatively stable and allows us to focus on other topics.

Mexican policy makers, on the other hand, continually keep an eye on the movement of their currency because the peso has endured a number of rapid freefalls throughout its modern history. The cause is often a sudden drop in exports, which causes businesses to exchange fewer dollars for pesos. This puts a downward pressure on the value of the peso and generates unease amongst investors. Afraid of a rapid drop, these investors pull their money out of the country, consequently exacerbating the very drop they were afraid of.

In the fall of 2008, as the US financial crises was causing severe loses at the New York Stock Exchange, Stephen Jen, the chief currency strategist at Morgan Stanley, predicted that nations like Mexico would soon face currency and financial shocks. He said, “the US financial sector has been the epicenter of the global crisis. I fear that a hard landing in emerging market assets and economies will become the second epicenter in the coming months.” If you look at the history of developing economies this was a pretty safe prediction.

But in Mexico, Jen’s forecast has proven incorrect. Despite an adjustment in the price of the peso in early 2009, there was never a freefall. Why is this? Why has the Peso shown resilience in the face of a severe recession? Why hadn’t investors pulled their money out of the country at the first sign of turbulence like they had in the past? I had been asking myself these questions since I arrived in Mexico in November, and I presented them to just about anyone that wanted to listen. I also searched the web to see if anyone else was discussing it.

The best answer I found was in an academic paper covering this very topic, written by American University professor of economics Arturo C. Porzecanski. I encourage everyone to read it. Porzecanski stated that a number of factors contributed to Mexico’s – and most of Latin America’s – hardiness during this crisis. He also contrasted Latin America with Eastern Europe, which have suffered considerably during the crisis.

One factor is the debt that Mexico incurred prior to the crisis was primarily denominated in pesos, as opposed dollars. This was the result of a growth in the domestic bond markets for both the Mexican government and large Mexican corporations. In the past, Mexico’s credit channels were typically in dollars, which meant that if the peso dropped Mexican debt grew proportionally.

Porzecanski also explained that the current banking system is more locally self-sufficient than in the past. In other words, money for loans was earned in the same markets where these loans were distributed. Finally, he stated that at the beginning of the crisis, the level of both public and private debt in Mexico was relatively low. This added a layer of credibility to finances and kept investors fears at bay.

I think Mexico has taken a crucial step over the past 10 years and, perhaps, the peso is no longer a particularly volatile currency. This story, however, isn’t over. Recent troubles in Venezuela and Argentina can spill into Mexico despite the improvements in its financial stability. Also there are still real problems in the Mexican government, from corruption to economic policies that hinder productivity.

These problems can slow growth and with the recession not over yet, investors may still get scared away. In emerging economies, policy makers really have two sets of constituents – their citizens, and international investors. If they don’t keep both confident and happy, they will face problems.