Focus

September 09, 2022 | 13:47

Mexico: Peso Perky but Policies Polarizing

Economist

Senior Economist and Vice President
Economics

Sarah Howcroft conducts risk analysis across a range of countries and industries in which BMO has strategic inte... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Shelly Kaushik

Economist
Economics

Shelly joined BMO Economics in 2020 and conducts research on U.S. regional economies. She also provides support ... (Read more)

Priscilla Thiagamoorthy

Economist
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Sarah Howcroft , CFA

Senior Economist and Vice President
Economics

Sarah Howcroft conducts risk analysis across a range of countries and industries in which BMO has strategic inte... (Read more)

Douglas Porter , CFA

Chief Economist and Managing Director
Economics

Douglas Porter has over 30 years of experience analyzing global economies and financial markets. As Chief Econom... (Read more)

Sal Guatieri

Senior Economist and Director
Economics

Sal Guatieri is a Senior Economist and Director at BMO Capital Markets, with over two decades experience as a ma... (Read more)

Benjamin Reitzes

Managing Director, Canadian Rates & Macro Strategist
Fixed Income Strategy

Benjamin has been with the Bank of Montreal for over a decade. He is responsible for the Canadian macro-economic... (Read more)

Jennifer Lee

Senior Economist and Managing Director
Economics

(Read more)

Shelly Kaushik

Economist
Economics

Shelly joined BMO Economics in 2020 and conducts research on U.S. regional economies. She also provides support ... (Read more)

Priscilla Thiagamoorthy

Economist
Economics

Priscilla joined BMO Capital Markets in 2016 and plays a key role in analyzing Canadian household trends and the... (Read more)

Feature

Mexico: Peso Perky but Policies Polarizing

While almost no country has been spared the global inflation battle (with the notable exceptions of China and Japan), there is one region that seems to have gotten ahead of the curve in the current monetary tightening cycle. Central banks throughout Latin America have been raising rates with gusto since mid-2021 to tame decades-high inflation. As a result, their financial markets have been rewarded with relatively strong performances even amid the U.S. Fed’s aggressive hiking campaign. Case in point, next to the Russian ruble’s massive sanctions-defying advance, the next top performing major currencies against the greenback this year are those of Brazil, Peru and Mexico (Chart 1).

In this piece we’ll focus on Mexico both because of its role in the U.S.-Mexico-Canada Agreement (USMCA) and because the peso is one of the most actively traded emerging market (EM) currencies. Headline inflation reached 8.7% y/y in August, well above the central bank’s 3% target but relatively moderate compared with EM peers and close to the U.S. rate (8.5% in July). Inflation would be far higher were it not for the pledge from President Andrés Manuel López Obrador (widely known as AMLO) to keep a lid on consumer fuel prices. In fact, thanks to reductions in the excise tax on gasoline and subsidies to gas suppliers, Mexico’s energy inflation is among the lowest in the OECD. Nonetheless, Banxico, which has already raised rates by 450 bps to 8.50% since June 2021, is expected to continue hiking until the real policy rate is well into positive territory, which will likely require another 100 bps at least by early next year.

The peso’s performance is also a recognition of the Mexican authorities’ prudent fiscal stance and track record of macroeconomic policy credibility. AMLO reveres frugality. Recall, barely any fiscal stimulus was rolled out during the pandemic—with monetary policy doing all the heavy lifting—and the general government budget deficit only reached 3.9% of GDP [1] in 2020 (versus 8.8% on average for Latin America and 10.5% for the advanced economies). AMLO is thus prepared to make spending cuts as necessary to prevent any material deterioration in the deficit or debt ratios through the end of his term in 2024. This fiscal restraint has helped preserve Mexico’s investment grade sovereign credit ratings, but it is not a panacea. Keep in mind, high energy prices are a double-edged sword as they entail a windfall to oil-related government revenue (and, importantly, reduce the need for transfers to the state oil firm PEMEX) and an offsetting cost due to the above-mentioned fuel subsidies.

Beyond the next couple years, in order to maintain a stable fiscal trajectory, the country needs more domestic-led growth. What growth the economy has seen of late has largely been externally driven. Needless to say, a deeper downturn in the U.S. would have grim consequences, as that economy accounts for roughly 80% of Mexico’s exports, 70% of tourists and 95% of foreign remittances. Workers’ remittances have trended higher since 2016, accelerating sharply during the pandemic, and now exceed the country's petroleum exports (Chart 2).

Mexico’s economy was a laggard among EMs even prior to the pandemic, with real GDP averaging growth of just 2.0% in 2015-19 and having yet to regain its 2018 peak. Investment trends have been particularly sluggish (Chart 3), reflecting both increasingly limited budget flexibility and AMLO’s interventionist and unpredictable policy approach, which has undermined business confidence since he took office in 2018. This, combined with the lack of pandemic-related fiscal support, is expected to lead to some long-term scarring in the economy, with medium term potential growth estimated at a relatively modest 2%.

Mexico does stand to benefit from the updated USMCA and ‘nearshoring’ of supply chains in North America, and recent data indicate an uptick in foreign direct investment in certain sectors (i.e., manufacturing). But, given ongoing impediments to the business environment—including high labour market informality, endemic crime and corruption, and regulatory uncertainty—this potential is unlikely to be realized before a more market-oriented government takes power. Although some of AMLO’s more contentious constitutional reform efforts have been rejected in Congress (including, most recently, an attempt to effectively nationalize the electricity sector), he continues to seek ways to unilaterally bolster the role of the state at the expense of private enterprises. It’s also possible that power constraints will hamper Mexico’s industrial growth given that the electricity sector, which requires substantial investment to expand capacity over the next decade, remains mired in legal disputes.

Bottom Line: The Mexican authorities will ensure that the fiscal position remains stable and inflation is gradually returned to target over the next couple of years barring any new shocks. However, longer-term prospects for investment and GDP growth are likely to remain weak so long as AMLO continues to control the political landscape. Although he is not eligible for a second term as president, he is still broadly popular and could remain highly influential if the next administration is led by his party, which looks likely at present.

Focus

Mexico: Peso Perky but Policies Polarizing

Mexico: Peso Perky but Policies Polarizing

Footnote:

[1] Budget deficit refers to public sector borrowing requirements, as per IMF convention for Mexico. [^]