This week the exchange rate in Mexico broke the floor of 17.50 pesos per dollar. It traded as high as 17.40 sometime on Monday, May 15. This level of the exchange rate has not been observed since at least 2016 and contrasts with the level of 19.44 with which it began the year and with its highest point in the last 12 months, which reached 21.04. What explains this strong appreciation of the Mexican peso and how far will it go? Will this trend be reversed?
The reasons behind the appreciation of the Mexican peso are of two types: external and internal. The external factor is that the US dollar has been weakening across the board in recent months. This weakness of the dollar is associated with the possibility of a recession in that country and the expectation that interest rates there will stop rising, in part precisely to try to avoid such a recession. This makes the U.S. currency unattractive, especially at a time when interest rates in other countries are relatively high.
You have to see what has happened with other Latin American currencies to understand that this phenomenon is widespread. From January to date, both the Chilean peso and the Colombian peso have appreciated by 7% against the dollar, while the Brazilian real has appreciated by around 10%. For its part, the Mexican peso is the currency that has appreciated the most in the region, accumulating an 11% recovery in the same period. This behavior shows that the Mexican peso is not unique, but it also illustrates that there must be something else that explains why, within the currencies of the region, the Mexican peso is the one that has shown the greatest strength. This has to do with factors of a different nature, of a rather internal character.
The internal factors behind the so-called superpeso are the strength of the fundamentals of the Mexican economy and attractive domestic interest rates. This combination of factors makes the entry of foreign currency into the country very attractive, which is what tends to appreciate the Mexican peso. Note, however, that these elements do not act separately, but together. High interest rates without good economic fundamentals do not attract capital, as shown by the case of Argentina, where the interest rate is already around 100%.
In contrast, in the case of Mexico, the strength of its economic fundamentals largely explains the strength of the Mexican peso. This is because investors perceive that the relative political, economic and social stability of the country guarantees them good returns with low risk.
What investors observe is that Mexico has maintained fiscal responsibility, that public debt is at reasonable levels, and that the country emerged from the pandemic with a stronger fiscal position than other countries in the region. They also note that the autonomy of the Bank of Mexico in the conduct of monetary policy has been respected, which guarantees that the control of inflation will remain its priority objective and that this institute will be able to make its decisions freely without being subject to political pressure.
To all this is added a very favorable position with the outside. Manufacturing exports today are 30% higher than the level they had before the pandemic, remittances continue to grow steadily, while foreign investment continues to flow at a good pace and with good expectations ahead due to the issue of the relocation of companies from Asia (the so-called nearshoring).
These good economic fundamentals are behind the so-called superweight. This is what makes the difference with other countries in the region and that guarantees that what we are observing will not be a temporary phenomenon. Of course, the high interest rate differential between Mexico and the United States (of around six percentage points) also helps, but this, as already said, would not be enough to explain the phenomenon we are observing.
Now, how far will this situation go? Will the Mexican peso continue to appreciate or has it already touched its floor? Could this trend suddenly be reversed? Although it is impossible to know for sure, it is very likely that the exchange rate has already touched its floor or is about to do so. It is not unreasonable to anticipate that the exchange rate observed on May 15 could have been the lowest point of parity in this episode. This could be explained because everything indicates that the interest rate gap between Mexico and the United States will no longer continue to grow and could even begin to narrow towards the last quarter of the year. With this, the incentives for appreciation would end and we could begin to see a gradual return of the exchange rate to higher levels.
In any case, the structural factors already mentioned would prevent the exchange rate from suffering an abrupt modification and rather we should expect a behavior with moderate fluctuations in a relatively limited range of between 17.50 and 19 pesos per dollar in the coming months. Fortunately, the strength of the Mexican economy guarantees a relatively stable exchange rate, which would free us from the episodes of financial turbulence that have accompanied other changes of government in the past.
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