Bar another sharp drop in oil prices, we expect the peso to begin performing better in relative terms. The Mexican peso fell over 20% against the dollar over the last 12 months. This puts the currency in the middle of the pack between its Latin America peers, but considerably worse than most other EM currencies. Many of the negatives have already been priced in, and officials have turned very vigilant towards FX volatility.
We think Banxico would focus first on FX in taking action to mitigate any negative ripple from Fed tightening. The central bank already stepped up its FX intervention policy. They could easily increase the amounts they auction or tinker with the trigger for intervention, which could help cap volatility. But Mexico has relatively few FX reserves compared with many other EM countries, so they may be reluctant to burn through them.
The bank has stated that it will follow the FED in tightening rates to prevent the fallout from narrowing rate differentials. Banxico even changed its meeting calendar a few months ago to put it more in sync with its northern neighbour. The minutes to the last meeting showed that the decision to keep rates unchanged at 3.0% was not unanimous, with one member voting for a 25 bp hike. The rational of the dissenter was to pre-empt the Fed’s move and the potential disruption it may cause. We never believed that Banxico would move prior to the Fed. In fact, we are not even convinced that the bank will necessarily move in lockstep with the Fed – it will depend on the reaction of the peso. It could even hike by more, depending on market conditions, but we doubt this will be the case.
The fiscal side is getting worse, unsurprisingly, but not enough to change the central bank’s reaction function. The deficit rose to 1.9% of GDP in the first half of the year, up from 1.4% during the same period last year. Although revenues increased by 7.1%, expenditures grew by 10.7%. Also of note, the public sector debt stock rose around to 42% of GDP, up from 39% a year earlier. Oil prices played a large role, but other factors also impacted higher spending. The disappointment from the first oil exploration auctions doesn’t help. But there are several more auctions ahead and ample opportunity for the government to improve its offering. We will find out in the second round of auctions in September 30.
On the political side, the government remains under pressure. Despite the victory in the parliamentary elections, President Pena Nieto’s image is severely damaged from corruption allegations and the escape of drug cartel lord “El Chapo” from a high security prison. The good news for him is that the opposition is not doing that well either. There is a lot of time until the 2018 elections. For now, governability is not the main problem the country is facing.