Peso Me Mucho

Resilience has not been a word historically associated with the Mexican peso — or more accurately, the Nuevo Peso, the currency introduced in 1993 when the original peso collapsed, resulting in the famous rescue of Mexico’s economy by President Bill Clinton’s economic team.

In the ensuing years, through the introduction of the North American Free Trade Agreement (NAFTA), the explosion of drug-related violence, the emerging markets investment boom of the early 2000s, and the 2008 global financial crisis, Mexico’s currency has fluctuated widely — sometimes wildly — and almost always in accordance with the performance of its most important trading partner: the United States.

But something new appears to be happening to the peso. Mexico’s steady economic rise — anchored by its adherence in recent years to more responsible fiscal and monetary policies — has made the peso a far less volatile investment vehicle, and more importantly for Mexico, a more reliable anchor for its global economic ambitions.

The change was on display in September, when market players across the emerging markets were thrown into a tumult by rumors that the U.S. Federal Reserve would begin "tapering," the banker’s euphemism for an end to the policy of quantitative easing that began after the onset of the 2008 financial crisis.

As fears of a replay of the 1997 Asian financial crisis gripped global markets, governments and central banks manned the barricades. For about 10 days in mid-September, carefully worded statements aimed at allaying fears issued daily from datelines more recently associated with record-setting levels of foreign direct investment. India and Indonesia raised interest rates; Brazilian and Malaysian officials spoke of new currency controls, and, with Jakarta and others, announced new stimulus spending. In Turkey, a veritable caravan of officials offered repeated assurances that the country was not running out of hard currency.

But Mexico — judging by its famously volatile currency at least — sailed right through the tempest. While the peso was hardly unaffected, it was an afterthought compared with the Turkish lira, Brazilian real, Indonesian rupiah or Indian rupee, all of which were the subject of precipitous sell-offs.

In the end, the Fed shifted course, electing to maintain its $85-billion-a-month bond-buying program in the short-term at least. And with the outcome of the recent debt-ceiling debacle still uncertain — this month’s 11th-hour deal to stave off default merely kicked the crisis forward a few months until February — has most analysts predicting that tapering, for now at least, is off the agenda at the Fed’s policymaking body, the Open Markets Committee.

But the relatively stable performance of Mexico’s currency through the tapering mini-panic has turned heads. Not only has the peso broken into the Bank for International Settlements’ annual listing of the top 10 most-traded currencies (the peso sits at no. 8), there is now widespread agreement among market analysts that Mexico’s economic reform program, and its shift in tactics in the violent drug war, are both paying dividends.

"The changes to the monetary policy framework, along with greater fiscal discipline and the adoption of a more flexible exchange rate, soon bore fruit," Bernanke said at a celebration of 20 years of policy independence organized by the Mexican Central Bank in September. "The improved monetary policy framework, together with other reforms, has thus far helped reduce Mexico’s susceptibility to financial crises."

Once a byword for currency crisis and global market contagion in the mid-1990s, Mexico has transformed itself into a solid and potentially powerful example of how to build an economy that will not founder when the weather changes. While Mexico remains highly connected to the giant U.S. economy — its leading indicators are still strongly correlated — expanded trade in Asia and Latin America, coupled with a burgeoning middle class in Mexico itself, has given the country a new sense of control over its own destiny.

"The fact that Mexico gets almost 80 percent of its export revenue from the United States has been viewed as a mixed blessing," said Shannon O’Neil, a senior Latin America fellow at the Council on Foreign Relations. Mexico suffered disproportionately during the U.S. downturn, but its own 2009 recession proved to be the "V"-shaped one that conservative economists searched in vain for in the U.S. economy. In part, this reflected the fact that Mexico has clawed back much of the ground it lost to China in the first decade of the millennium, as rising Chinese manufacturing costs, along with other factors, made America’s southern neighbor more competitive.

Mexico’s quick recovery from the financial crisis also speaks to its native strengths, which distinguish it from other emerging markets where credit too often led GDP growth. The country boasts a thriving manufacturing sector — largely the result of NAFTA — and privileged access to the world’s largest consumer market at a time when the U.S. is recovering. With a growing middle class, relatively low inflation, and stable monetary policies, Mexican growth — and perceptions of the peso — is based on solid fundamentals rather than the QE-fueled global credit bubble.

Mexico’s major commodity export, oil, is also in better shape than most people think. The country’s production peaked in 2003 at 3.4 million barrels per day (bpd) and has since fallen steadily (to 2.5 million bpd) as mature fields — "easy oil," in industry parlance — began to run dry. But new technologies that extend the life of declining wells — coupled with the fact that Mexico has one of the world’s largest potential reserves of shale gas and tight oil — have painted a more encouraging picture. This explains why President Enrique Pena Nieto has made the opening of the oil and gas sector — closed to foreign investment since nationalization in 1937 — the centerpiece of his reform agenda. (The technologies needed to revitalize the industry — particularly the complex trial-and-error techniques of hydraulic fracturing — are beyond the abilities of Mexico’s state-owned petroleum company, PEMEX.)  

The full impact of such reforms — which enjoy the support of Pena Nieto’s Partido Revolucionario Institutional (PRI) as well as the conservative opposition — may still be a few years away, but global currency markets are already registering approval. Progress toward removing lingering impediments to exploiting Mexico’s huge conventional and shale reserves will only add to the peso’s allure.

"To paraphrase Warren Buffett, only when the tide goes out do you discover who’s been swimming naked," said Nicholas Watson, the Bogota-based head of Latin America research at the consultancy Control Risks. "2014 will expose the divide between these countries and their more pragmatic cousins, led by the likes of Chile and Mexico, which enjoy considerably better economic fundamentals than in the past that will better insulate them from market volatility." 

Unlike Brazil, with which it is invariably and incongruously compared, Mexico has relatively little exposure to weakening Chinese demand for raw materials (and thus to lower commodity prices), a problem also bedeviling Peru, Chile, Colombia, and many other emerging market countries that depend on commodity exports. Mexico’s trade with China is relatively small — one reason Pena Nieto made a point of visiting Beijing on his first overseas trip — but NAFTA has positioned Mexico as an alternative to China’s "workshop of the world" model, and lately it’s been paying off for Mexicans.

Of course, there’s still the drug war, which continues to overshadow Mexico’s economic progress. But even on that front, there are some encouraging, if ambiguous, signs. With investor concerns very much in mind, Pena Nieto’s administration has attempted to bring down overall violence levels by scaling back the aggressive counter-insurgency tactics of his predecessor, Felipe Calderón, who deployed army troops and waged open conflict with the cartels.

Pena Neito’s administration recently claimed that homicides declined by 18 percent in 2012, although it conceded that kidnappings rose by almost 35 percent during the same period. (Even that mixed result is challenged by some analysts who cite the culmination of a turf war between Mexico’s Gulf cartel and Zeta gang as the reason for the homicide decrease.) Nonetheless, the level of violence has continued to fall — or at least hold steady — during Pena Nieto’s first year in office. In his State of the Union address in August, the Mexican president said that the murder rate had fallen an additional 13.7 percent between January and August of 2013 — though there a reasons to be skeptical of such claims.

Whatever the true trajectory of the drug war, global markets are focused on a different set of graphs altogether: GDP growth, proven oil reserves, per capital income, and the resilience of the peso — all indicators that show Mexico in a highly favorable light. Investors in the United States and Japan, in particular, appear to regard Mexico as something of a hedge against the tumult most believe will afflict other emerging market economies when the Fed does finally put the brakes on QE.

"The cartel violence is serious, but it is contained geographically and has not prevented the rest of the country from modernizing and growing the economy," said CFR’s O’Neil, author of Two Nations Indivisible: Mexico, the United States, and the Road Ahead.

The outlook hasn’t always been this bright. After all, it was less than two decades ago that a devaluation of the peso — known to economists as the 1994 Tequila Crisis — sent shockwaves all the way to Washington and prompted the U.S. Treasury to risk political disaster at home with a $20 billion bailout loan.

The episode seems to have cured Mexican policymakers of their penchant for loose fiscal policy. As Bernanke’s remarks suggest, Mexico’s Central Bank hasn’t forgotten the nasty hangover left by the Tequila Crisis. And having survived the harrowing dress rehearsal for the day when the Fed’s largesse actually is removed — and both Bernanke and his successor, Janet Yellen, have been at pains to stress that day will come — Mexico may find that its currency, for once, is a breakwater rather than a conduit for global economic contagion.