At play with the peso: variety of factors must be gauged to grasp oft-wild movements in the nation's currency.

"What will the exchange rate be at the end of the year?" is a question to which most everyone would like to know the answer.

For businesspeople reporting results in foreign currencies, the exchange rate can ruin a great year in pesos. Businesspeople operating in pesos don't escape the vagaries of exchange rate movements either: anytime they have suppliers' debts in foreign currencies, they are susceptible to seeing their profits evaporate. Vacation plans have been scotched because of unexpected movements in the parity.

In Mexico, we had become used to seeing the peso go only one way against the dollar--down. That changed when the Zedillo administration, out of necessity, decided to adopt a floating exchange rate regime. The peso has depreciated since 1995, but there have been periods in which it has posted a substantial appreciation. A dollar cost 9.5% less, for example, in January of 2002 than it did three years earlier.

In the first four of the last five years, the peso was basically stable. Between 1999 and 2002, the average exchange rate either depreciated (a modest 4% or less in 1999 and 2002) or appreciated (1% or a bit more in 2000 and 2001). The average exchange rate in 2002 was just 1.4% lower than in 1999. In 2003, however, the average exchange rate slipped 10.3% against the dollar. Between the middle of December 2003 and the middle of January 2004, the cost of a dollar climbed to 11.4, then dropped to 10.8. By early March, the dollar cost over 11.0. What's going on? Is the peso's trajectory in 2004 likely to be more similar to that of 1999-2002 or to 2003?

A QUESTION OF INTERVENTION

That question was answered in 1995 with the adoption of the floating exchange rate regime. It has served the country well. For the past eight years--and there's no change in sight--the peso-dollar parity has been determined by daily supply and demand for each currency. Mexico's float isn't a perfectly clean one; the Banco de Mexico does intervene from time to time. However, the interventions are carried out on the basis of pre-ordained rules, which give certainty to the markets that the government is not manipulating the parity.

For example, in March of 2003, the Exchange Commission announced a mechanism to limit the accumulation of reserves. The government obviously was concerned about the rapidity with which the exchange rate depreciated in the first two months of 2003 and wanted to forestall a panic. Instead of intervening immediately in the markets by selling dollars, the Exchange Commission announced a rule governing the conditions under which it would sell dollars into the exchange markets.

The rule was transparent, and it gave the government no discretion over the timing or amounts of dollars sold: the Banco de Mexico would sell half the increase in reserves accumulated over a defined three-month period. The dollars would be sold in equal daily amounts over the course of the next three months.

The announcement had the desired effect. The peso appreciated without destroying confidence that the government would let the markets determine the parity. Since the mechanism was unveiled, there have been four announcements of sales.

CURRENT ACCOUNT EYEBALLED

Over time, the exchange rate should reflect the fundamentals of the economy--a country's growth and inflation performances, past and future. The current account deficit measures the economy's need for foreign capital while the capital account reflects the nation's ability to attract capital from abroad. If reserves rise, more money is coming into than going out of the country.

A rule of thumb is that deficits of up to 3% of gross domestic product (GDP) can be financed without difficulty. Mexico's 2003 current account deficit was only about 1.4% of GDP. Although the size and financing of the deficit hasn't been and shouldn't be a problem, there is an interesting dynamic occurring that has implications for the future, when the economy starts to grow again.

In Mexico, the trade account deficit is the critical determinant of the size of the current account deficit. When the economy barely grows, as has been the case in the first three years of the Fox administration, the trade account deficit shrinks, so the current account deficit becomes less of an issue.

As we've seen, when high oil prices accompany minimal growth, the current account deficit is not an issue at all. The more rapidly the economy grows, the larger the trade and, thus, the current account deficit.

If capital inflows don't pick up commensurately, the peso will weaken. However, there's been a factor in the current account deficit that's taken on new weight this year and that can help mitigate the centrality of the trade account in the current account picture: remittances by Mexicans working abroad.

SHORED UP BY REMITTANCES

Remittances have long been a substantial source of dollars for Mexico. Between 1998 and 2000, net transfers averaged US$6.4 billion/year, 90% of the average trade account deficit and 40% of the average current account deficit. In 2002, remittances reached US$10.3 billion, 30% more than the trade deficit and 73% of the current account deficit.

In the first nine months of 2003, remittances (see related story, page 46) matched their full year 2002 level, more than double the January-September trade account deficit and 80% larger than the nine-month current account deficit.

Why have remittances soared? Part of the answer is in geopolitics. Mexicans who have crossed the U.S. border are reluctant to return and therefore send money home instead of bringing it. Another part of the answer is in the dramatic reduction of transaction costs. A major success of the Fox administration has been to slash the commissions charged illegal immigrants when they send money back home.

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Lower transaction costs are an incentive to remit money in forms that can be caught in the balance of payments. Another part of the answer is methodological. The Mexican authorities changed the methodology they've been using to report remittances.

The third-quarter current account numbers illustrate the impact of the leap in remittances on the current account deficit. The third-quarter current account deficit was US$1 billion less than in the third quarter of 2002. Net remittances were US$1.2 billion higher than a year earlier, easily compensating for the US$200 million increase in non-factor services (principally tourism). The trade account deficit and factor service payments (principally interest) were basically the same as a year earlier.

How much of the reason for the jump in remittances is geopolitical, how much lower transaction costs, and how much methodological isn't known. What is obvious, though, is that if net remittances stabilize at a time when the economy is growing rapidly, Mexico's need for capital inflows will rise.

MONEY, IT FLOWS

A different type of transfer was behind Mexico's capital account surpluses through 2002 and the first half of 2003--large positive numbers in the assets held abroad account, which translate into capital inflows for Mexico. In 2002, US$11.77 billion of assets were repatriated to Mexico from accounts abroad, 35% more than the largest such inflow since the economy first began opening in 1985.

In the first six months of 2003, US$3.78 billion was brought back to Mexico, more than in all of 1998. In the third quarter of 2003, however, those inflows dropped off to the point of almost ceasing: only US$590 million was repatriated, an important part of the explanation as to why the capital account surplus turned into a deficit in the third quarter.

Granted, the third-quarter capital account deficit was a minimal one, just US$120 million. But, the manner in which the categories that make up the capital account are evolving isn't particularly auspicious: not as much capital is coming in and debt repayments use it up.

Is is surprising that, for the first time in three years, reserves declined in the third quarter of 2003? In spite of the US$1.28 billion dip in reserves between June 30 and September 30, 2003, Mexico's reserves (theoretically unnecessary in a floating exchange rate regime) remained close to US$60 billion.

IMPACT OF INVESTMENT

Declining foreign investment also played a part in putting the capital account in deficit. Although the US$8.09 billion in direct foreign investment (DFI) amply covered the US$5.73 billion current account deficit, DFI was still a disappointing 20.8% less than in the first nine months of 2002 and the lowest level for the nine-month period since 1997.

Between January and September, half of DFI went into manufacturing and a quarter into financial services. DFI will certainly fall short of the US$13.1 billion/year it has averaged (excluding Citibank's purchase of Banamex in 2001) over the preceding six years.

DFI will continue to be a mainstay of the capital account, but the January-September 2003 figures suggest it's not wise to be complacent about Mexico's attractiveness as an investment destination. DFI won't disappear, and it will finance at least four-fifths of the current account deficit in the near term. However, the slowdown in DFI highlights the obstacles to competitiveness that the failure to proceed with institutional and structural reforms have raised.

The more preoccupying question, though, is what will happen to the peso if the present political turmoil and willful blindness of politicians who insist there's no energy problem or that the solution to the government's fiscal problem is more taxes on producers and/or captive taxpayers.

FEEL THE 'NOISE'

Ultimately, the exchange rate will be determined by the underlying economic fundamentals of a country. Those include: growth prospects; inflation; government finances; the current and capital accounts; political, economic and social stability; and investors' perceptions of a country's possibilities. In the short-term, however, markets are subject to perturbations, the "noise" that is the source of the day-to-day volatility in the exchange rate.

A recent example of how events can have an immediate and significant impact on the exchange rate is the evolution of the peso-dollar parity between November and the first half of February. In November, optimism abounded that Congress would approve a meaningful fiscal reform.

The exchange rate stood at about 11.2 and the benchmark one-month Cete rate averaged just below 5%. In mid-December, bitter infighting in the Institutional Revolutionary Party (PRI) not only doomed the proposed fiscal reform, it also raised the specter that the PRI would split. The exchange rate soared to 11.4 and interest rates followed suit with the one-month Cete rate climbing to an average of 6.06%.

Exchange and interest rates didn't stay at those levels long: the one-month Cete rate fell in the next four consecutive auctions, dropping to 4.69% at the end of January. The exchange rate appreciated almost 4% between mid-December and the middle of January, falling to 10.8. By mid-February, interest and exchange rates had moved back up. In the second primary auction of February, the one-month Cete rate soared 71 basis points (0.71 percentage points), to 5.59% and a dollar cost about 11.1 pesos.

What explains the peso's trajectory over those two months? The peso's abrupt depreciation and the jump in interest rates in response to the failure of the fiscal reform is easy to understand. The peso's subsequent appreciation and drop in interest rates can be seen as an illustration of "overshooting," the term used to describe a market overreaction and February's movements, as a response to "undershooting" in January.

The movements can also be read as the outcome of the placing and unwinding of speculative positions taken by treasuries, often of banks. As long and short positions are taken and unwound, the exchange rate moves.

Seasonal flows also affect the exchange rate. In Mexico, the trade and current account deficits are typically lowest in the first quarter of the year. DFI inflows, in contrast, don't demonstrate any seasonal patterns. It's not surprising that since the exchange rate has been floating, depreciation tends to be steeper in the last four months of the year.

One-off operations can move the exchange rate significantly in a short period. If large acquisitions are structures to involve transfers into or out of pesos, the exchange rate will reflect those funds flows. For example, when Citigroup purchased Banamex for US$24 billion in 2001, the amounts involved were so large that care was exercised to bring funds in over time and to leave some of the funds in dollars.

In early February, we saw the peso see-saw based on the announcement that the Spanish bank BBVA intends to spend US$4.1 billion to acquire the 41% of Bancomer it does not yet own. The peso strengthened on the announcement, then weakened when Central Bank Gov. Guillermo Ortiz said he wouldn't approve the transaction if it were up to him.

FINAL PREDICTIONS

The macro-economic fundamentals argue that the peso should depreciate this year, but not substantially. Last year's adjustment brought the peso-dollar parity closer to what purchasing power parity valuations would suggest is an appropriate level and, more importantly, businesspeople aren't complaining that the peso is too strong or too weak.

Depreciation more or less in line with the difference between the U.S. and Mexican inflation rates is reasonable. Of course, if the repatriation of capital were to stop or become an outflow, the depreciation would be higher. And, there's always the possibility of another terrorist attack in the United States, debilitating political turmoil at home or a break-through on the president's long-awaited structural reforms.

All in all, AMCHAM is betting on the macro-economic fundamentals and no surprises, pleasant or unpleasant, in its exchange rate projection for 2004.

Dr. Deborah L. Riner is AMCHAM's chief economist.

Analysis by Dr. Deborah L. Riner