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Jakob Wilhelmus
Senior Research Analyst, International Finance and Macroeconomics Research
Capital Flows and Finance and Regulation and Systemic Risk
Jakob Wilhelmus is a senior research analyst in international finance and macroeconomics at the Milken Institute. He studies topics relating to systemic risk, capital flows, and investment. Concentrating on market-level information, his work focuses on identifying and analyzing financial data to produce a better understanding of the behavior and underlying...
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Brexit Reverberations Add to Mexico’s Troubles

By: Jakob Wilhelmus
June 29, 2016
   
   

Most commentary around Brexit focuses on the implications for the European Union and its geographic neighbors. However, one of the effects of globalization is that, just as your morning coffee travels thousands of miles before reaching the cup, the negative spillovers of economic events reverberate around the globe. Right now, some of the aftershocks of the Brexit vote are hitting Mexico.

For many years, Mexico has welcomed capital internationalization and has continued to attempt reforms to grow their financial markets and overall economy. As a result, the Mexican Peso has become one of the most traded [i] currencies and is used by many investors as a proxy for Latin America’s emerging markets. The peso has become a freely usable currency — one that is used for international payments and is widely traded on exchange markets. As a result, it reacts quickly, and sometimes harshly, to international reallocations.

Sword of Damocles: A Weak Peso and Low Oil Prices

Since Britons voted to leave the EU on July 23, the peso has plunged, reaching a historic low on July 27. [ii] In general, a weakening currency is not a bad thing. (Remember all the assertions that currency wars by way of negative interest rates would lead to weak currencies and economic growth?) Weaker currencies make exports cheaper and thereby boost demand, but for Mexico, the peso’s decline may have become too much of a good thing.

This is primarily due to two issues: inflation and dollar-denominated debt. Exports and imports react inversely to a change in the exchange rate, so as exports become cheaper, imports become more expensive. Mexico is a net importer of many basic agricultural products, including corn from the U.S. Eventually, the higher cost of imported corn will have to be passed on to households or the government will have to increase its corn subsidies. Unless the government is willing, and capable, of taking on this bill, higher corn prices for consumers will lead to an increasing inflation rate that will quickly be felt by the entire population and put pressure on economic growth.

weakening mexican peso 

debt structure pemexThe second issue in play is the government’s dependence on the state-owned oil producer Pemex.[iii] In past years, Mexico’s oil resources provided around 30 percent of the annual fiscal budget. This dependency is nothing new, but since the drop in oil prices, the company — and with it the Mexican government — is finding itself increasingly in trouble. Last year the government’s income from oil dropped to 20 percent of the total budget, the lowest value in the past decade. The core issue with regard to the domestic currency, however, is the fact that Pemex’s debt is mostly denominated in U.S. dollars. Further declines in the peso would put an additional financial burden on the distressed company.

This problem is not limited to Pemex. Many companies would have to seriously realign if the central bank doesn’t lean against the weak peso by raising interest rates. Therefore, given all the different negative effects that a (too) weak Peso has on the Mexican economy, there is no question that the central bank will decide to increase rates during their meeting tomorrow; but this itself worsens the risk of recession. It also reiterates the question about the fiscal budget that will have to be answered at some point: If oil fails to produce the revenue that the Mexican government needs, what will?

 


[i] According to SWIFT the Mexican Peso is among the 10 most traded currencies worldwide.

[ii] There are other domestic issues—rising municipal debt, political tension, and violent clashes between government forces and the teacher union in Oaxaca—that without a doubt have a role in the recent weakening of the Mexican Peso, but for the sake of brevity we will attribute the recent collapse mainly to the Brexit.

[iii] Keep in mind that while Pemex has dollar debt it also receives most of its revenue in dollars. However, due to the recent development in oil prices and the maturity mismatch of its balance sheet, these do not offset each other entirely.