Monday, February 22, 2016

Mexican Two Step

Last week, Banco de Mexico and the Mexican government delivered a double whammy to the financial markets (excerpt):

Mexico Battles Emerging-Market Bears With Surprise Peso Defense

The Mexican government’s unprecedented steps to protect the peso are off to a good start.
The currency posted its biggest rally in five years Wednesday after officials said they will increase the benchmark interest rate, reconfigure an intervention program to contain volatility and reduce government spending. It advanced another 0.5 percent on Thursday. The new measures came after the peso plunged 8.9 percent to start the year, the worst performance among major currencies, and was down 31 percent over the past 18 months as investors sold off emerging-market assets.

Mexico finds itself in a peculiar situation: While its economy is in relatively good shape -- with gross domestic product growth forecast to accelerate for a fourth straight year, a booming manufacturing industry led by auto production and inflation near a record low -- its currency has been battered more than most. A plunge in oil prices and concern the global economy is slowing have had an outsize effect because the currency’s high liquidity and low borrowing cost make it a favorite for traders seeking to hedge risk.
“The peso for some reason has been depreciating more than other emerging-market currencies while the fundamentals have stayed reasonably solid,” said Gerardo Rodriguez, a New York-based money manager at BlackRock Inc. and a former deputy finance minister for Mexico. “Measures like these aren’t announced everyday. They’re what one would expect in this environment.”
All told, they raised the policy rate by 0.5% and announced spending cuts to the government budget worth 0.7% of GDP. Here's the purported reason for the policy moves (2012=100):

The chart above is an equal weight index of the MXN against the AUD, CAD and MYR (my favoured basket for net energy exporters). As you can see, the Mexican Peso has sold off precipitously this year, losing near 40% of its value in a matter of weeks, even as the other three currencies gained slightly on the USD.

Despite that, I think the Mexicans are bonkers.

Nothing in the data suggests a tightening of monetary or fiscal policy is warranted. Core inflation spiked to 2.6% in January, from 2.1% in December, but that's still below the central bank's target of 3% (with a range of 1% above and below). The government has a fairly low debt to GDP ratio and some external debt, but that has stabilised over the last half a year or so. As such, the recent decline in the Peso won't increase public external liabilities much. Private external liabilities include a large portion of foreign holdings of local currency debt (similar to Malaysia).

Monetary aggregates are showing decent growth, but that flatters to deceive - the growth is largely due to the base effect, and looking at the level data, money supply growth has flattened off in recent months. Bank credit growth is accelerating, but that's largely due to credit granted to the government, not consumer or business credit which could signal higher future inflation pressure. The stated excuse of tamping down on inflation expectations by pushing up the exchange rate is bogus. Imported inflation, much like for the other three currencies, has been a no show to this particular party.

Contrast this with what happened to the MYR (2012=100):

The Ringgit suffered a similar drop in the second half of last year, from which it has since recovered. I don't think the Mexican sell off would last much longer before relative fundamentals reassert themselves.

In other words, it looks to me like this move to bolster the currency is for no other reason than to bolster the currency, and in a somewhat panicky way at that. And that's not a good reason for a policy response, especially since the double-whammy of simultaneous monetary and fiscal tightening threaten the growth and stability of an already slowing economy. To put it another way, the authorities are bringing the Peso in line with fundamentals by not only trying to make the Peso stronger, but by making the fundamentals weaker.

So why am I suddenly talking about a country half way around the world?

For one thing, the Mexican economy shares some structural similarities with Malaysia, from credit rating to oil & gas production to being a large open trading nation. For another thing, there's the juxtaposition with a similar move by another Latin American country last week (excerpt):
Colombia Follows Mexico With Rate Rise, Budget Cut, FX Plan

Colombia became the second Latin American nation this week to raise interest rates, cut government spending and announce steps to shore up its currency as commodity prices tumble.

A majority of the seven-member board voted to increase the policy rate a quarter point to 6.25 percent, bank Governor Jose Dario Uribe told reporters in Bogota after the meeting. The decision was forecast by 26 of 33 economists surveyed by Bloomberg with the rest expecting a half-point rise.

Colombia is racing to buttress a currency that has tumbled 27 percent in the past 12 months, helping pushing inflation to more than double the target. To prevent another abrupt depreciation, the central bank lowered the trigger at which it will intervene in the foreign exchange market, while Finance Minister Mauricio Cardenas announced spending cuts to crimp the fiscal deficit and bolster investor confidence. The series of measures are similar to those taken Wednesday by Mexico. Peru also raised its key rate last week....
A perfect teaching moment, which I could never resist.

Almost identical moves with almost identical aims, but in very different circumstances. Colombia is suffering from a stubbornly high inflation rate of over 7%, well above the central bank's target of 3%. The real rate of return is negative even after this rate hike, which means further rate hikes are both likely and warranted. A cut in the fiscal deficit is warranted too, as the current account is also in deficit. Colombia's policy moves makes sense within the context they were made; Mexico's does not.

Lesson 1: Different circumstances will require different policy measures;

Lesson 2: The same policy measures will have different effects under different circumstances;

Lesson 3: Don't confuse intermediate objectives with ultimate final objectives i.e. keep your eye on the ball.

If the goal of policy is full employment growth with stable prices, Mexico looks like it has achieved that within the parameters it has established i.e. inflation around 3% and unemployment below 5%. The signal they're sending to investors now is that they're not willing to tolerate inflation above 3%, which means that 3% is not really a target but a ceiling. By the same token, the trade off implies that they are also willing to tolerate growth below potential. But the whole point of stabilising inflation expectations is to maximise long term potential growth. This tension between achieving short versus long term policy objectives seems to me like they've lost sight of the ball.

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