Will Mexican Peso Crisis of 1994 repeat itself?

Having risen to a six-year high against the Dollar in late 2008, the Mexican Peso seemed to have firmly distanced itself from the devastating financial and economic crisis suffered in the early 1990’s. However, all of the factors that were blamed for the earli

er crisis have since re-emerged, leading some analysts to question whether a repeat is possible. According to a report published by the Atlanta Fed shortly after the 1994 crisis: The main fly in the ointment was Mexico’s current account

deficit, which ballooned from $6 billion in 1989 to $15 billion in 1991 and to more than $20 billion in 1992 and 1993. To some extent, the current account deficit was a favorable development, reflecting the capital inflow stimulated by Mexican policy reforms. However, the large size of the deficit led some observers to worry that the peso was becoming overvalued, a circumstance that could discourage exports, stimulate imports, and lead eventually to a crisis.

Sound familiar? A future (hypothetical) report that follows the looming currency crisis will likely point to a similar inflow of speculative capital and a surging current account deficit, which has reached the highest level since 2000. Given that “the size of the deficit may more than double this year as industrial production, foreign direct investment and money transfers from abroad continue to fall,” the likelihood of peso devaluation is rising, regardless of how low the currency has already fallen.

On the one hand, Mexico’s response to the weakened Peso is promising. With the blessing of the US (which played a prominent role in the 1994 crisis), the Central Bank of Mexico has injected Billions of Dollars directly into the forex market, so as to keep up the facade that everything is under control. At the same time, it hasn’t lowered interest rates nearly to the extent of some of its peers, in order to guard against inflation and appeal to investors with comparatively attractive yields.

Unfortunately, there are a couple reasons why both prongs of this strategy will backfire. On the monetary policy side of the equation, investors would actually prefer steeper interest rate cuts. The carry trade is functionally dead, and investors are now primarily concerned with the risk of deflation, which only becomes more likely as a result of higher interest rates. In other words, the consensus is that the Central Bank should stop griping about inflation, and focus instead on stimulating aggregate demand, since the Mexican economy is especially vulnerable due its dependence on (oil) exports to the US. The Central Bank is also likely to fail in its efforts to directly prop up the

Peso, because of the tide of speculators betting against it. To quote the same Atlanta Fed report: A sudden shift of funds out of a currency is called a speculative attack in the economics literature…

Rather than waiting for the central bank’s reserves to run out through a gradual process of curren

t account deficits, speculators who realize that a devaluation is inevitable will attack the currency through massive capital outflows as soon as they command enough resources to force a devaluation. Most analysts have since turned bearish on Mexico, which means the fall of the Peso has become self-fulfilling. Check out the Mexican Peso ETF (FXM), which represents a simple and effective way to bet against (or for, for all of the contrarians out there) the

Peso.

Forex Achieves New Prominence

The credit crisis has resulted in a collapse in prices for nearly every type of investable asset class (i.e. stocks, bonds, commodities, real estate)- with the notable exception of one: currencies. Of course, this is an inherent quality of forex: a rise in one currency must necessarily be offset by a fall in another currency. While you are probably rolling your eye at the obviousness of this observation, it is still worthwhile to make because it implies that there is always a bull market in forex. Accordingly, capital from both institutions and retail investors continues to pour in to the forex markets, causing daily turnover to surge by 41% (according to one survey), which would imply a total of $4.5 Trillion per day!

Investment banks, especially, are trying to increase their forex business in order to compensate for a decline in other divisions. Said one representative: ”We have probably made more of an aggressive leapfrog in growing our revenue base, which has virtual

ly doubled in 2008 versus 2007. With the situation that has been developing over the past six months, where banks are clearly re-embarking on a new role leading back to basics, foreign exchange has to be one of the products that tops that list.”

Based on New York data, which generally reflects global forex activity, transactions between the Dollar, Euro, and Yen (i.e. not involving outside currencies) now account for more than half of the total.

Contrary to popular belief, however, most foreign exchange transactions involve derivatives, rather than spot trades. In the case of swaps, it is the nominal value of the swap that is reported, which well exceeds the total amount of currency that is exchanged, and thus results in an inflated estimate of total daily turnover. Regardless, all measures point to increasing volume.

One would expect that the increase in both liquidity and the role of derivatives in forex markets would result in a corresponding decrease in volatility. Of course, this is quickly belied by the turbulence of the last six months, in which many currency pairs set daily, weekly, and/or monthly records for fluctuations and volatility.

I recently read an article about so-called “predictive markets,” which use a grassroots approach to make forecasts by “by giving people virtual trading accounts that allow them to buy and sell “shares” that correspond to a particular outcome. Shares in an outcome that is considered more likely to occur then trade at a higher price than those that represent a less likely outcome.” Given that the forex ‘experts’ are almost invariably wrong, I think this idea has tremendous potential to make forex markets even more transparent. Of course, that also means that it will become more difficult to turn a profit, which is why “it’s vitally important to be well-informed when investing in forex so as to enter and exit trades only at levels that are ‘fundamentally’ sound.”

UK, EU Central Banks Follow the Federal Reserve

Yesterday, both the European Central Bank (ECB) and the Bank of the UK cut their benchmark interest rates to record lows. This is especially incredible in the case of the UK, whose Central Bank over 300 years old! You can see from the following chart that both Central Banks have more than made up for their respectively slow starts in easing monetary policy by effecting several dramatic rate cuts, following the example of the Federal Reserve. The baseline UK rate now stands at .5%, only slightly higher than the Federal Funds rate, and slightly lower than the 1.5% ECB rate.

Given that they have essentially reached the terminus of their monetary policy options, all three Central Banks are exploring further options aimed at pumping money into their respective economies. The Fed has already “announced a program to buy $100 billion in the direct obligations of housing related government sponsored enterprises (GSEs) — Fannie Mae, Freddie Mac and the Federal Home Loan banks — and $500 billion in mortgage-based securities backed by Fannie Mae, Freddie Mac and Ginnie Mae.” As I wrote in a related article, “this was quickly followed by repurchase programs, lending facilities, investments in money market funds, and option agreements, all of which were designed to supplement its ‘traditional open market operations and securities lending to primary dealers.’ The Fed’s efforts also work

ed to ease the liquidity shortage in credit markets abroad by entering into swap agreements with several foreign Central Banks suffering from acute Dollar shortages.” In conjunction with the rate cut, the Bank of the UK, meanwhile, will pump £150bn directly into UK credit markets through liquidity support, buying public and private debt, and asset purchases. “The main purpose of quantitative easing is not to send the money supply into orbit but to stop it from crashing…the broad money held by households has risen at a worryingly slow rate over the past year, and holdings by private non-financial firms have actually

been dropping.” In contrast to the monetary programs of the UK and US, the ECB has thus far refrained from the kind of liquidity support that would necessitate printi

ng new money. Instead, “the central bank will continue offering euro-zone banks unlimited loans at the central bank’s policy rate until at least the end of this year.” The interest rate cuts were announced simultaneously with a spate of macroeconomic data, which collectively paint a bleak picture. Eurozone growth is projected at -2.

7% for 2009 and 0% for 2010. The current unemployment rate at 8.2% and climbing. The thorn in the side of the EU is represented by eastern Europe, where growth is falling at an alarming pace, dragging the EU down with it. While EU member states have pledged to intervene if one of their own falls into bankruptcy, it’s unlikely that they would intervene similarly if a non-EU member state went bust. The UK economy is similarly desperate, having contracted at an annualized rate of 5.8% in the most recent quarter. The wild cards are the real estate and financial sectors, the fortunes of which are increasingly intertwined.

So what do the forex markets have to say about all this? Economists have used the dual phenomena of risk aversion and deflation to explain the interminable weakness in the the Pound and Euro. Everyone is surely familiar with the notion of the US as “safe haven” during periods of global financial instability. The deflation hypothesis, meanwhile, suggests that the ECB (and to a lesser extent, the Bank of UK), fell behind the curve when easing liquidity. The ECB, especially has harped on inflation as a reason for cutting rates more quickly. Given that investors are now more concerned with capital preservation than price inflation, it follows that they would prefer to invest where Central Banks were more vigilant about deflation (i.e. the US).

Personally, I think that the continued declines in both currencies, in spite of steep interest rate cuts, indicates that the deflation hypothesis is bunk, and investors remain fixated on risk aversion. By no coincidence, the temporary rebound in US stocks that took place in January was also accompanied by a bump in the Euro. (See chart below).

I think this mindset is reasonable, but only in the short-term. Given the current economic environment, I don’t think investors (and currency traders) can be faulted for ignoring the possibility that quantitative easing and liquidity programs will have to be funded with the printing of new money, which would be inherently inflationary. Many comparisons are being made with Japan, whose ill-fated quantitative-easing program succeeded only in inflating a bond-market bubble and vastly increasing Japanese public debt. According to one columnist, “it’s hard to argue that quantitative easing ended deflation; high oil prices did that. Meanwhile, the economy cured on its own most of the structural problems such as excess capacity and too much debt associated with the deflationary environment.”

In short, with a medium and long-term investing horizon in mind, I think the ECB’s approach to dealing with the credit crisis is more conducive to monetary stability. Thus, when investors grow weary of the idea of US as safe haven, they will no doubt focus instead on fundamentals. At which point, the ECB will likely be rewarded for fulfilling its anti-inflation mandate, in the form of a stronger Euro.

Strong Dollar Hurts US Businesses

While the year-long surge in the Dollar has been a welcome development for American consumers and the US government (in terms of cheaper imports and easy credit, respectively), American businesses are not smiling. The strong Dollar has resulted in decreased competitiveness in the eyes of foreign consumers, and consequently, lower exports. For this reason, the US trade deficit has not shrunk significantly, despite a slight down-tick in imports. One must also look at the overseas earnings of American multinational corporations, which are frequently repatriated to the US and booked in Dollar-terms. In fact, as much as 50% of S&P 500 member company profits now come from overseas. Simply, lower exchange rates mean lower profits. In short, investing in the stocks of companies as a proxy for the markets in which they do business is not (as) profitable when the Dollar is strong. The Financial Times reports:

As a result of this greater impact of currency swings, companies are starting to put greater emphasis on trying to hedge their foreign exchange exposure, according to a recent survey from JPMorgan.

US and Japan Should Form "Forex Partnership"

While continuing to deny the possibility of direct forex intervention, Japan is nonetheless desperate to halt the rise in the Yen. The primary concern of the US government, meanwhile, is not that the Dollar is becoming too valuable, but rather that it will face great difficulty in funding its economic stimulus plan. Perhaps there exists a golden opportunity to simultaneously alleviate both of these quandaries; Japan should be solicited to buy US government bonds. A large-scale purchase of US Treasury securities by the Central Bank of Japan would be tantamount to intervention, and would probably lead to a decline in the Yen, at least against the Dollar. Of course the US would benefit not only by the direct purchase of its bonds, but also by the positive signal that this would send to other institutional investors. Besides, given that China is in no position to increase its holdings of US Treasury securities, Japan represents the best candidate for partnership. The Washington Post reports:

Achieving such a currency adjustment may seem farfetched, but the yen-dollar exchange rate historically has been heavily influenced by the market's perception of the U.S. and Japanese governments' comfort level for the currency relationship.

Chinese Yuan: Up or Down?

Speculation surrounding the Chinese Yuan has been mounting for months, beginning with a sudden halt to the currency's appreciation and continuing with the insinuation of the Obama administration that China is a currency manipulator. In the context of falling exports and a sagging economy, meanwhile, the Chinese Ministry of Finance has issued a research report encouraging the Central Bank to allow the currency to appreciate. Despite the Central Bank's insistence that it wants a "stable" currency, futures prices indicate a mean expectation that in fact, the Yuan will be nudged downward over the next twelve months. On the other side of the equation are financial analysts, who collectively forecast a slightly stronger Yuan, with one bullish analyst projecting a 3.5% appreciation in 2009, on the basis of selectively culled economic data. Bloomberg News reports:

“The consensus around China has been weak growth and falling reserves. The recent data challenges both views. Lending looks good, money supply looks good, and the PMI balanced to slightly bad from very bad levels."