Thread: Beyond borders: Mexico struggles against US pull

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Beyond borders: Mexico struggles against US pull
Bu John Authers in Mexico City
Published: June 20 2005 17:03 | Last updated: June 20 2005 17:03

us canada mexico tradeThe Bank of Mexico faces an unusual question this week: how to decouple from the US? This seems ironic, as Mexican history over the past 10 years has been about cementing the country's ties with the US and integrating its economy as much as possible, notably through the North American Free Trade Agreement.

The ties with the US have helped win Mexico an economic stability that is much envied across the rest of the region.

But when it comes to monetary policy, many in Mexico believe the link with the US has gone too far.

Mexico's central bank does not set interest rates directly, instead it uses an opaque mechanism known as the corto to restrict liquidity. It has increased the amount by which the money market must stay short eight times since the beginning of last year in an attempt to choke off the inflationary effects of various supply shocks.

But the bank expects the markets to react wholeheartedly to any tightening by the US Federal Reserve, which entered its own restrictive cycle months after Mexico.

The bank maintains its position through the language used in its twice-monthly communiqués on monetary policy. Mexican overnight rates must match a Fed rise basis point for basis point, and the bank will intervene to achieve this if necessary. Any doubt about this policy was erased in February when Mexican banks did not match a Fed rise in full and the Bank of Mexico responded by setting a minimum in its daily auction, in effect forcing them to do so.

This approach no longer seems sustainable. Mexican overnight rates are now at 9.75 per cent. Matching expected Fed tightenings would entail taking interest rates above 10 per cent. Even though the Bank of Mexico is independent, this would be politically unwise.

Economically, it appears unnecessary. Mexico enjoyed a decent economic recovery last year but there are signs the tight money policy is beginning to damp it. Indicators of industrial activity, such as the purchase of new machinery, have shown a marked deceleration so far this year, even though industrial activity in the US, to which it is usually tightly linked, has continued to increase. That implies interest rates are too high.

And the battle against inflation appears to have been won. "Core" inflation - a number that strips out the effects of prices beyond the control of monetary policy, such as basic agricultural products or fares and charges set by the government, now sits at an all-time low of 3.42 per cent.

Why does Mexico, an investment grade country, need to have overnight rates of 9.75 per cent? Those rates are also having an effect on the currency, because foreign investors cannot resist the "carry trade" that can be achieved by buying Mexican bonds. The differential over US rates is so high that money has poured into Mexico, helping push the Mexican peso to its highest level in 18 months - an odd circumstance for a country that needs to use hawkish monetary policy to deal with its inflation problem. So it would appears to be time to move on from the tightening cycle.

Having reached this position, however, the problem is how to move away from it. An obvious step, now overwhelmingly expected by the market, would be to remove the "coupling" language from Friday's communiqué. This would signal that Mexican rates would not have to follow the next Fed rate rise.

But the use of the corto creates a problem. If it stays constant for a while, interest rates can start to move down. With the corto unchanged, and no requirement to shadow the Fed's moves, the likelihood is that rates would start to fall sharply. This would not sit well with the hawks on the central bank's board. Something beyond the corto appears to be necessary to control monetary policy once the bank abandons its coupling to the Fed.

Although core inflation seems to be under control, headline inflation, at 4.6 per cent, remains unacceptably high, thanks largely to volatility in the prices of foodstuffs, such as tomatoes. It is unlikely to reduce significantly until the last quarter of this year. Hawks on the board will not want to let rates drop too far while inflation remains at these levels.

This suggests the "carry trade" has a few months left, although not much more. It also creates a problem for the Bank of Mexico. How can it decouple from the Fed without allowing Mexican interest rates to slide too quickly? The most obvious solution would be to abandon the corto and move to a reference rate. This would have the benefit of transparency but it might be difficult to achieve with only a year to go before the presidential election.

The level of political invective in Mexico is already high and a reference rate would make the bank's policy more transparent. A few interest rate cuts might lead opposition politicians to claim they are part of a pre-election giveaway.

Should the bank decide not to go down this route, the most likely alternative would be "telephonic persuasion", calling to tell the banks not to cut interest rates too quickly. A more technical alternative would be to introduce a formal system for setting a "floor" on interest rates at auction. Either way, the small print of Friday's policy communiqué will be worth reading.

I would like to see them "de-couple" from the U.S. permanently!!! No love lost on this side of the border!