The Emerging Call
Focus: Mexico’s Overvalued Peso (Summary)
Emerging Markets Research
José M. Barrionuevo
Emerging Markets Strategy
jose.barrionuevo@barcap.com
+1 212 412 3306
www.barcap.com
Please read carefully the important disclosures at the end of this publication.
September 11, 2003
Growth and the Peso
Strong economic growth was the greatest achievement of Mexico’s bright exports period.
Following the 1994-95 crisis, growth averaged 5% during 1998-2000. More importantly,
the Mexican economy moved in sync with that of the United States, as NAFTA helped
integrate its business cycle into the United States’ business cycle. Industrial production also
became much more closely correlated between the countries, as a low 25% correlation
during Q1 1980-Q3 1991 doubled to 52.5% during Q4 1991-Q2 2003, effectively
replicating GDP performance in recent times.
Still, Mexico’s growth is also more volatile than that of the United States, surpassing it during
upturns but underperforming it in slowdowns or downturns. Ahead of the presidential
elections of 2000, Mexico outperformed US growth by 1%, as the United States grew by an
average 4% during 1998-2000. However, it underperformed US growth during the recent
global slowdown. As the US recovery gathers momentum, Mexico’s growth should
outperform US growth based on past history. However, past growth was led by sharp export
performance that may not materialize this time. The strong tie between US and Mexican
growth may be changing now, and Mexico’s growth could lag the US recovery for the first
time in almost a decade.
After President Fox took office in December 2000, Mexico’s growth performance weakened
markedly, as investment and exports declined sharply. The slump has been prolonged
enough that both investment and exports have yet to recover. Growth was flat by the end of
the first half of 2003, averaging only 0.5% thus far during the Fox sexenio. In contrast, the
United States grew by 1.5% during 2000-03. By the end of the first half, Mexican growth had
fallen again to 0.2%.
In addition to the political failure of the Fox administration in advancing critical fiscal and
foreign investment reforms and the US slowdown, Mexico’s growth has been hindered
severely by an overvalued currency. The recent decline in Mexican exports reflects not only
sluggish US growth, but the persistent overvaluation of the peso and the damage that it
inflicts on their international competitiveness, especially given China and Central America’s
low labor costs.
The value of the MXN real exchange rate is more important in driving exports than is widely
believed. It is standard view of Mexican export performance is that US growth is the leading
driver of growth and that the real exchange rate is of little of no importance. While there is
no doubt that US growth is most critical to Mexican exports, the real exchange rate is also
 important and is a crucial driver of Mexican exports, given the impact of US demand on
relative prices.
Besides the credit costs of MXN devaluation that hindered export growth, capital inflows
often obscured the tie between the real exchange rate and exports. Indeed, during periods
of strong US growth and US investment, net capital inflows would lead to a sharp nominal
and real appreciation of the peso. At the same time, though, stronger US demand and
Mexican investment would boost Mexican exports. The erroneous conclusion, of course, is
that exports would be negatively related to the real exchange rate. During periods of
economic contraction in the United States and in Mexico as well as net capital outflows, the
opposite would happen. Mexican exports would fall at the same time that the real exchange
rate is depreciating. This suggests that allowing for credit flows, or the resulting Mexican
output capacity, should help identify the underlying link between exports and the real
exchange rate more accurately.

Why the Peso Matters to Growth

When the US economy is sluggish, competing on a cost basis is the only way Mexican
businesses can preserve the country’s export and output capacity, allowing for a quick
turnaround during periods of US expansion. The widely held view is that Mexican exports
are only driven by US growth and that relative prices have little or no impact. This view
reflects most econometric estimates of partial equilibrium export models that find that the
real exchange rate is either not significantly related to Mexican exports or that it is
inversely related to exports. US GDP is all that matters. Unfortunately, most of these
estimations lead to spurious relations between exports and US GDP and the real exchange
rate, due to a strong serial correlation in the error term that yields unstable and unreliable
estimates that are effectively useless.
The peso appears irrelevant to exports because the real MXN/USD is related inversely to US
output and, to a lesser extent, Mexican GDP. Accordingly, the negative estimated
relationship between exports and the real exchange rate is in fact the part of exports that is
not explained by income effects measured by the level of US GDP and that, therefore, picks
up the relative price impact of US GDP which happens to be inversely related to the real
exchange rate. The neoclassical model indeed suggests that relative prices aren’t
exogenous and, in turn, are determined by GDP levels, including supply effects. Supply
moves of relative GDP in both countries are critical drivers of the impact of the real
exchange rate on exports. While Mexico takes international prices as a given, correcting for
the impact of US output on relative prices still remains critical to find a reliable estimate of
the impact of the real exchange rate on exports.
Once Mexican output capacity becomes part of the specification of export performance
together with US GDP and the real exchange rate, the relation that characterizes the
behaviour of exports improves markedly. Because Mexican exports have gone from being
28% of GDP in 2000 to about 23% today, a 7% rise in export growth would result in a
contribution to economic growth of only 1.5%, rather than the 3.5% rise in growth that
would follow a fair valued peso. Accordingly, evidence of lagging export growth in coming
months would finally lead to a sharp correction of the MXN peso. We look for the MXN
peso overvaluation to correct in the fourth quarter of 2003, should weak Mexican exports
fail to match strong US growth.

2 Emerging Markets Research Barclays Capital

 The MXN peso is 6% overvalued at its recent level of MXN 11, suggesting a fair value of
MXN 11.7 (Figure 1). While peso depreciation since January 2002 has reduced the level of
peso overvaluation from its 20% peak in 2002, the peso remains overvalued. Indeed, with
the most overvalued level of the peso since the early 1980s, the longest period of peso
overvaluation since the mid-1990s and the sharpest overvaluation since the peso was
floated, the MXN peso should continue to adjust lower should Mexican manufacturing and
textile investment and, hence, exports remain weak (Figure 1). Because investment
prospects remain closely tied to progress on reforms, investment in manufacturing and
maquila industries are unlikely to recover this year, suggesting that the overvalued peso
may limit the ability of Mexican exports to compete with China and other exporters, at least
in the early phase of US recovery. As a result, Mexican growth could lag US growth, leading
to an adverse decoupling that would lead the MXN to fall markedly during the fourth
quarter of 2003 to close at MXN 11.5, instead of MXN 11.25 as we had estimated before.
Furthermore, investment is also unlikely to recover until the MXN reaches a more
competitive level, in our view.

Figure 1. MXN Real Exchange Rate % Valuation Adjusted for Productivity

Gains (Fair Value=0%)
60.00%

50.00%

40.00%

30.00% + Undervaluation

20.00%

10.00%

0.00%

-10.00% - Overvaluation
-20.00%
Worst MXN Overvaluation since 1980s Debt Crisis
-30.00%
Jan 80 Jan 82 Jan 84 Jan 86 Jan 88 Jan 90 Jan 92 Jan 94 Jan 96 Jan 98 Jan 00 Jan 02

Source: Banco de Mexico; Barclays Capital, Inc.

While it’s important that the MXN peso is the most overvalued since the early 1980s and for
the longest period since the mid-1990s, this doesn’t mean that the situation is the same. In
fact, the 1980s debt crisis was triggered by large fiscal deficits, while the 1990s crisis was
due to poorly capitalized and badly managed banks. Both crises followed large financial
imbalances that could have understated the degree of MXN overvaluation. This time
around, however, there are no significant financial vulnerabilities and, in fact, pension
reform is contributing to build a savings base that will cushion the magnitude of economic
adjustments in the future.
In this setting, recent MXN overvaluation was exacerbated by the March FX policy change
regulated by the Secretaria de Hacienda y Credito Publico, which led the foreign exchange
market to anticipate that Pemex dollar sales were bound to appreciate the MXN. In our
view, the move was poorly timed and contributed to exacerbate Mexico’s present economic
weakness. At the time there were concerns over US and Mexican growth, both of which

Barclays Capital Emerging Markets Research 3

 were consistent with a weaker level for the MXN. In fact, the measure was announced two
days after the MXN peso hit its lowest level of MXN 11.23 thus far this year on March 5.
The new FX regulation is highly pro-cyclical and thus contributes to exacerbate
recessionary pressures during periods of weak growth. In fact, many periods of sluggish US
growth have been the result of adverse oil price hikes. Higher oil prices mean higher
Mexican oil exports and, therefore, higher USD sales in the local market at a time when
weaker growth suggest a weaker MXN peso, not a strengthening MXN.

US Growth and China

Because US growth is the leading driver of Mexican exports and indeed growth, many of
Mexico’s structural growth impediments have been down played. While a rising tide in the
US would undoubtedly raise Mexican boats and thus economic growth, the risk to the
envisaged export growth is that a period of prolonged, sharp peso overvaluation could lead
businesses to shut down their operations in Mexico and shift them to other more cost
competitive countries, such as China and El Salvador. To the extent that Mexican export
capacity is adversely affected and investment doesn’t return soon because the peso stays
overvalued, export growth may lag a US recovery. In our view, this scenario is taking place
now, but hopefully leading the way to a peso correction that makes Mexican exports
competitive on a cost basis. This is not to say that devaluation is a desirable policy to
strengthen exports. Indeed, the Mexican experience is the opposite: conscious efforts to
devalue the currency have only led to financial costs that more than offset the trade
benefits. Future growth would undoubtedly come from further structural improvements to
Mexico’s economy and ability to compete. Such changes, however, are lagging enough that
export growth is being adversely impacted by limited investment opportunities and
relatively high production costs, warranting a more competitive peso.
China, however, has done precisely the opposite. With policies that invest in education and
infrastructure in a highly underdeveloped economy, China’s ability to compete is surging.
Millions of Chinese poor are becoming part of rapidly growing industries and improving
education standards. In contrast, Mexico’s poor, which still represent well over half the
country’s population, can’t be part of the labor force because they lack basic education and
training and because an increasingly obsolete infrastructure keep them isolated from
mainstream, investment grade Mexico. These are well over fifty million Mexicans. Opposite
to them are the few, privileged that lobby hard to keep the country as one of the closest
economies in the world to foreign investment. Regulations are also being simplified in
China, while Mexico’s past efforts for simplification have been replaced by a new and
buoyant burocracy (or “burro-cracy as frequently said in popular jargon).
The Chinese monetary authorities are also pursuing monetary and FX policies that prevents
the Yuan from appreciating to enhance the competitiveness of Chinese exports. This has led
the US and the IMF to repeatedly call for an appreciation of the Chinese currency to reduce
growing trade imbalances. The Chinese response, which effectively mimics the regional FX
policy, is that the Yuan should stay competitive for as long as growth of China’s leading
trading partners remains weak to preserve the country’s export capacity. This is certainly
changing now that the US is beginning to grow, but the strong trade performance has given
way to a sharp accumulation of dollar assets that the Chinese are now trying to exchange
for profitable investments everywhere in the world, recently in Latin America. The result is
that China’s exports to the United States have grown markedly, while Mexico’s have

4 Emerging Markets Research Barclays Capital

 declined. In fact, China is expected to replace Mexico as the US second largest trading
partner behind Canada as early as this year.
While keeping a currency arbitrarily undervalued is not a desirable policy, relying on an
overly-tight monetary policy and thus overvalued currency to bring inflation down when
the world is not growing much is not desirable either. Indeed, in our view, the peso should
be supported by a monetary policy that is tied to the least amount of inflation that is
consistent with limited deviations of the MXN peso from its fair value along the business
cycle. In fact, during periods of weak US growth, the MXN peso should be allowed to fall
enough to keep Mexico’s export capacity on a cost basis. Instead, peso strength is becoming
costly enough to Mexican business that many of them are closing in a country that has the
best competitive advantage of the emerging world: location. During periods of weak US
growth, the real exchange rate is especially important to ensure that Mexican exports can
compete on a cost basis and to an extent that keeps Mexican export capacity so that when
the US economy turns around exports can quickly recover.
Despite the prolonged period of weak US growth and weak Mexican export growth, the
MXN peso has failed to fall enough to close its overvaluation gap. Not surprisingly, Mexico’s
competitive advantage of being next to the United States and still having low labor costs
would only strengthen Mexican exports once the peso falls to its fair value near MXN 12,
rather than the present MXN 11. While fiscal costs and an ambitious inflation target usually
lead to a tight monetary policy bias in Mexico, the cost to the country in the way of
foregone exports and jobs is greater than the cost to the government of somewhat higher
debt service costs. It simply makes Mexican exports too expansive for US and global
markets, suggesting that the peso should be should be allowed to find its competitive value.
During periods of cyclical growth weakness, this would result in peso depreciation that
allows for the most efficient, relative price adjustment that would mitigate the output and
employment cost to the Mexican economy. Indeed, the high cost of sharp wage hikes and
the mighty peso are severely restraining Mexico’s ability to grow. While only structural
reforms would lead to a permanent increase in Mexico’s export capacity, in their absence a
weak peso remains the only way to keep Mexico’s hardly won export capacity.
Precisely because of no progress on non-financial structural reforms, a competitive peso
becomes a critical policy priority to preserve Mexico’s export capacity. There is no doubt
that US growth remains a critical driver of Mexican exports and that when the US economy
grows capital inflows appreciate the peso at a time when exports are rising due to a
recovering US economy. When US growth is sluggish, the peso needs to fall enough to
preserve Mexico’s export and output capacity. This is exactly what hasn’t happened this
time around. In all, the damage inflicted by an overvalued peso when US growth is weak
risks indeed being serious enough that exports may lag the next US recovery simply
because they are gone.

— Jose M. Barrionuevo +1 212 412 3306

Barclays Capital Emerging Markets Research 5

Barclays Capital
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New York, NY 10166
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Emerging Markets Strategy José M. Barrionuevo Gustavo Rangel

Head of Emerging Markets Strategy, +1 212 412 2056
Americas gustavo.rangel@barcap.com
+1 212 412 3306
jose.barrionuevo@barcap.com
Matthew Vogel Desmond Supple
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(44-20) 7773-2833 (65) 6395-3210
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