For those tracking global currencies, particularly in emerging markets, the performance of the Mexican Peso against the US dollar has been a noteworthy anomaly. While many emerging market currencies have experienced depreciation amid the Federal Reserve’s monetary tightening that began in March 2022, the Mexican peso has bucked the trend. It has appreciated significantly, climbing approximately 20 percent against the dollar. This resilience prompts a crucial question for anyone interested in the Dollar Currency In Mexico and the broader economic dynamics at play: what factors are fueling this unusual peso strength?
This robust performance is particularly significant considering Mexico’s deep economic ties with the United States. Mexico is a major player in the US economy, poised to potentially overtake China as the top US trading partner. Understanding the forces behind the peso’s strength offers valuable insights into the Mexican economy and its relationship with the dollar.
This article delves into the multifaceted reasons behind the Mexican peso’s impressive performance against the dollar. We will explore both short-term dynamics and long-term macroeconomic fundamentals that contribute to the peso’s unexpected strength in the current global economic landscape.
Alt Text: Mexican Peso Appreciation Against the US Dollar: Chart showing the percentage change in the Mexican Peso to US Dollar exchange rate, highlighting the Peso’s strong appreciation since 2022.
High Interest Rates: A Magnet for Dollar Investment in Mexico
One of the primary drivers behind the peso’s attractiveness, and consequently its strength against the dollar, is the substantial interest rate differential between Mexico and the United States. Interest rates play a pivotal role in currency valuation. A higher interest rate associated with a currency, relative to another, makes it more appealing to investors, assuming exchange rate stability. Investors seeking higher yields are naturally drawn to currencies offering better returns.
This principle underpins the “carry trade,” a popular strategy where investors borrow funds in a low-interest-rate currency (like the US dollar) and invest in a higher-yielding currency (like the Mexican peso) to capitalize on the interest rate difference. Derivative instruments like futures and foreign exchange swaps further facilitate these trades.
The real (inflation-adjusted) policy rate differential between Mexico and the US started widening in 2021 when Banco de México proactively began raising its policy rate. This monetary tightening began almost a year before the Federal Reserve initiated its own rate hikes.
Alt Text: Real Policy Rate Differential Between Mexico and the U.S.: Graph illustrating the widening gap between Mexico’s and the United States’ real policy rates, showcasing Mexico’s proactive monetary policy.
Banco de México’s cumulative policy rate increase of 7.25 percentage points surpassed the Federal Reserve’s 5.25 percentage points. At its peak in late 2022, this differential allowed carry trade investors to potentially earn around 7 percentage points in real return by borrowing in dollars and lending in pesos, assuming a stable dollar-peso exchange rate. While this gap has narrowed from its peak, it remains significant at approximately 4 percentage points, continuing to support the peso’s appeal in the foreign exchange market.
Compared to other emerging markets, Mexico offers a favorable risk-reward balance. Its interest rates are significantly more attractive than those of lower-risk Asian economies, while its macroeconomic policies are perceived as more stable than many other high-yielding Latin American nations. Furthermore, the Mexican peso is the third most traded currency among developing countries, enhancing its liquidity and attractiveness for carry trades.
Fiscal Prudence: Bolstering Investor Confidence in the Mexican Economy
Mexico’s fiscal policy during the pandemic also played a crucial role in strengthening investor confidence and, consequently, the peso. In contrast to many nations that implemented massive stimulus packages, Mexico maintained a relatively modest fiscal deficit of about 4 percent of GDP during the pandemic. Its pandemic-related stimulus was equivalent to just 1.1 percent of GDP, significantly lower than the Latin American average.
Alt Text: Fiscal Deficit in Mexico: Chart comparing Mexico’s fiscal deficit as a percentage of GDP with the Latin American average, emphasizing Mexico’s fiscal discipline during the pandemic.
While this fiscal restraint may have contributed to a slower economic recovery compared to some peers, it had a positive impact on Mexico’s credit risk. Lower fiscal deficits reduced concerns about government debt sustainability, making Mexican government bonds more attractive to investors. This combination of high-interest-rate carry and lower fiscal risk has been a significant factor underpinning investor confidence in Mexico and its currency.
Remittances: A Strong External Anchor for the Mexican Peso
Another key factor supporting the peso’s strength is the robust flow of remittances from Mexicans living abroad, particularly in the United States. Remittances represent a significant and stable source of external income for the Mexican economy. In 2022, remittances reached a record $55.9 billion, equivalent to 4.5 percent of Mexico’s GDP, a substantial increase from 2.5 percent a decade prior.
Remittances act as a reliable source of foreign currency, reducing the need for external borrowing and supporting the current account balance. The current account balance reflects a country’s net demand for foreign currency. Without these substantial remittance inflows, Mexico’s current account deficit would have been significantly larger, potentially exceeding 4 percent of GDP in recent years, increasing demand for foreign currency and putting downward pressure on the peso. Remittances helped keep Mexico’s current account deficit at a more manageable 1.2 percent of GDP in 2022.
Alt Text: Mexico’s Current Account Balance and Remittances: Graph showing Mexico’s current account balance as a percentage of GDP, highlighting the offsetting impact of remittances on the deficit.
Nearshoring Optimism: A Future Boost for the Mexican Economy and Currency
Optimism surrounding nearshoring, the relocation of manufacturing operations from Asia closer to the US, has also contributed to a positive outlook for the Mexican economy and the peso. Mexico is seen as an attractive alternative for companies seeking to diversify their supply chains away from China, aiming to mitigate risks associated with tariffs, enhance security, and improve supply-chain resilience by locating closer to the US market.
While the actual impact of nearshoring on aggregate foreign direct investment (FDI) is still developing, the anticipation of increased investment flows is creating a positive sentiment around the Mexican economy. While FDI in Mexico was relatively flat in 2021 and 2022, averaging 2.5 percent of GDP, below the pre-pandemic average, there was a slight increase in the first quarter of 2023. The majority of this increase appears to be from profit reinvestment rather than entirely new investments, suggesting nearshoring’s full potential is yet to be realized in hard data.
However, investor optimism, combined with Mexico’s solid macroeconomic fundamentals, is a potent mix that can bolster the peso’s strength. The narrative of nearshoring is contributing to a positive perception of Mexico’s economic prospects.
Investor Positioning: Reduced Foreign Debt Holdings Offer Stability
Investor positioning, particularly the decreased foreign ownership of Mexican government debt, has paradoxically contributed to the peso’s recent resilience. While foreign demand for government debt signals investor confidence, a high level of foreign ownership can make a country vulnerable to sudden shifts in investor sentiment and capital outflows.
During events like the “taper tantrum” in 2013, when unexpected comments from the Federal Reserve led to a spike in US Treasury yields, countries with high foreign ownership of domestic debt experienced significant currency depreciation. At that time, foreigners held nearly 35 percent of Mexican government domestic securities, and the peso depreciated sharply as investors sold Mexican bonds anticipating higher US rates.
Currently, foreign ownership of Mexican government debt has decreased significantly from around 25 percent at the start of the pandemic to approximately 15 percent. This decline, which began earlier due to concerns about US-Mexico trade relations and Mexican economic policy, meant that during the recent period of US monetary tightening, there was less foreign-held Mexican debt to be sold off. This lower foreign ownership likely limited capital outflows and reduced volatility for the peso.
Interestingly, the surge in peso demand has not been matched by a significant increase in foreign ownership of Mexican government debt or foreign bank exposure to Mexico. This suggests that the peso’s appreciation may be driven by investors gaining peso exposure through derivative contracts like foreign exchange swaps, for which public data is not readily available.
Real Effective Exchange Rate: A Return to Long-Term Value
Examining the real effective exchange rate provides another perspective on the peso’s strength. The real effective exchange rate measures a currency’s value against a weighted average of its trading partners’ currencies, adjusted for inflation differences. In the long run, absent major economic shocks, a currency’s real effective exchange rate tends to revert to its long-term average.
Some of the peso’s real effective exchange rate appreciation since 2020 can be seen as a correction following a sharp depreciation in 2015-16. Until late last year, the peso’s real effective exchange rate was close to its 30-year average. The recent appreciation has pushed it above this long-term average, suggesting a move towards a potentially more balanced valuation.
Alt Text: Mexican Peso Real Effective Exchange Rate: Chart showing the historical trend of the Mexican Peso’s real effective exchange rate, illustrating its recent appreciation above the long-term average.
Conclusion: A Confluence of Factors Underpins Peso Strength, But Uncertainty Remains
In conclusion, the Mexican peso’s remarkable strength against the dollar is supported by a confluence of factors: proactive monetary policy leading to attractive interest rate differentials, prudent fiscal management, strong economic ties with the US including substantial remittance inflows, and favorable investor positioning. While nearshoring could provide further support, its materialization is not guaranteed.
Looking ahead, some factors that have supported the peso may moderate. The interest rate differential between Mexico and the US has narrowed, and the peso’s real exchange rate is now above its long-term average. External shocks and shifts in global investor sentiment could lead to a reversal of carry trades. Furthermore, upcoming presidential elections in both the US and Mexico in 2024 introduce potential policy uncertainty that could trigger exchange rate volatility. While the peso has demonstrated remarkable resilience, these factors suggest that its future trajectory remains subject to both domestic and global economic and political developments.
