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.