Eliminating risk: peso loan pilot program saves Mexico a bundle.

A pilot program has just been signed that relieves the Mexican government of the risk involved in having to repay a loan in dollars.

Mexico suffered a series of peso devaluations from the 1970s through December of 1994, the most recent. More than a decade later, the situation has improved dramatically.

The country's currency has recently been dubbed the "super peso" as it continues to appreciate in value. In addition, the increase in trading activity between the United States and Mexico has led to a market for dollar-peso exchange.

The Interamerican Development Bank and the Mexican government-owned bank, Banobras, have joined forces to make peso loans to individual Mexican states and municipalities, substantially reducing the risk to Mexico if the super peso eventually loses strength and dollars become more expensive to pay back over time.

"The currency risk will be absorbed by the market, not by the borrower," observed Lawrence Harrington, director of the Interamerican Development Bank (IDB) in Mexico, during a speech delivered to the students of the Escuela Bancaria y Comercial, Mexico's oldest business school.

Promoting Transparency

In a move toward decentralization, the federal government is giving states and municipalities greater responsibility.

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Individual states are now in charge of their own highway construction and other development projects. The IDB's US$300 million loan to Banobras finances infrastructure and social services, supporting the move toward decentralization. The goal is to help modernize state and municipal public institutions and promote financial transparency.

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Article 117 of the Mexican Constitution, however, prohibits state governments from obtaining financing from foreign entities and further prohibits such financing in anything but pesos in an effort to avoid over-indebtedness.

As a result, a pilot project has been created in which the dollars the IDB loans to Mexico will be converted to pesos for use by the states without the Mexican government being responsible for any future peso-dollar disparity as the loan is repaid over a 25-year period.

"This is a ground-breaking development," says Raul Escalante, manager for International Operations at Banco Nacional de Obras y Servicios Publicos, more commonly referred to as Banobras. "We have moved the currency exchange risk from the Mexican government to the financial markets."

Procedural Details

Here's how it works. The IDB signs with an investment bank or other commercial entity to exchange cash flows from the loan in pesos to the loan in dollars. The investment bank returns this money to the IDB in Mexican pesos.

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The IDB then gives the money in pesos to Banobras, which, in turn, distributes the peso loans to individual states and municipalities which, by law, can only borrow in pesos.

When repaying the loan, the states need only deal with Banobras, paying in pesos.

Banobras repays the debt to the IDB in pesos with interest, according to the floating interest rate in pesos. The IDB then gives those pesos to the investment bank, which then uses the currency exchange derivative markets to change the pesos back into dollars.

Finally, the IDB receives its loan back in dollars. Although the peso is currently riding high, currency fluctuations can be very volatile.

With this agreement among the IDB, investment banks and Banobras, the Mexican government will be relieved of much of the risk involved in converting dollars to pesos and back again when dealing with major loans involving millions of dollars.

Reducing Risk

This can result in substantial savings that can be passed to the individual states.

In the past, Mexico was able to use many of the dollars the IDB lent it on goods that it bought abroad.

Now, however, the focus is on the country's infrastructure. Projects such as water treatment facilities, highway construction, and improving health and education require pesos. This makes changing dollars to pesos even more important.

Until recently, the Mexican market did not have sufficient depth or breadth for dollar-peso exchange transactions of any significant amount.

Now, because the Mexican financial market is relatively healthy, the country is capable of sustaining such major transactions, allowing this pilot project to go forward.

If this experiment goes as planned, it could benefit other countries as well.

"This pilot project enables us to watch closely what is working and what is not," says the IDB's Harrington. "We can take the lessons we learn in Mexico and apply them throughout Latin America where the financial markets make it possible."

Rhona Statland de Lopez is the education columnist for The Miami Herald International and teaches Journalism at Endicott College/Mexico.