Mexican meltdown? Mexico's strong peso may not be immune to a Latin American financial contagion.

Despite Washington's surprise move to rescue Argentina, the continuing financial crisis in Buenos Aires has caused a number of investors to start questioning the wisdom of treating Mexico as a "safe haven" from the turmoil that seems to be spreading around the region. The fact that Mexico is now part of the NAFTA trade bloc, Wall Street has believed until now, makes it different from Argentina, thus justifying investment managers' decisions to hold overweighted positions in Mexican assets and accept yields approaching those available north of the border. Yet investors may be surprised to learn that the Mexican peso actually has appreciated more than its Argentine counterpart and, more importantly, that the Bush administration believes Argentina can default on its foreign debt without affecting other countries in the region, particularly Mexico.

"The Bush administration was correct in withholding assistance until the Argentine government showed meaningful economic reforms," writes Walter Molano of BCP Securities in Greenwich. "But the latest IMF package for Argentina is a classic example of Washington at its worst. After several weeks of grandstanding by Treasury Secretary [Paul] O'Neill, Washington abandoned its rhetoric and announced a surprise rescue package for Argentina. The package appeared to have few conditions, if any. While we need to better understand the details, my advice to investors is to use this rally as a once-in-a-lifetime opportunity to liquidate remaining Argentine positions and get out of the door. The fact that the details of the package were nebulous and the new money was well below expectations, suggests that the U.S. Treasury gave Argentina enough rope so that it could hang itself. This way, the U.S. government cannot be held responsible for the impending collapse of the Argentine economy."

A major influence on Washington's early hands-off approach to the crisis in Argentina was Treasury Secretary O'Neill, an old fashioned Republican who in general eschews government intervention in the markets. O'Neill was highly critical of the International Monetary Fund's earlier bailouts for Turkey and Argentina and is said to adamantly oppose further measures to assist Argentina. Yet just as O'Neill made the mistake of publicly questioning Washington's existing "strong dollar" policy, a notion he was forced to abandon after an embarrassing public display of naivete, so too he has been forced to embrace the established policy of bailing out insolvent debtor nations like Argentina rather than force debt restructuring.

O'Neill now keeps his own counsel regarding the dollar, but insiders say his views on the financial markets and Third World bailouts have not changed, this despite the Argentina rescue. The real question is whether the U.S. Secretary of the Treasury understands how the rise of the dollar, fueled by the excessively high real interest rates maintained by the U.S. Federal Reserve Board during the past several years, has affected the international economy.

The Argentines "rashly decided several years ago to stabilize their economy by hitching the peso to the U.S. currency," Barry Riley of the Financial Times wrote in July. "But the dollar's relentless appreciation is tearing Argentina's economy apart ... [as] emerging market investors have raised the interest rate for financing the country's debt to well over 20 percent. A familiar group of usually suspect economies, such as those of Turkey and Brazil, is being sucked into a new crisis of secondline currencies."

Despite O'Neill's initial reticence about direct U.S. intervention, Washington has slowly come to support further International Monetary Fund assistance for the developing world's largest debtor nations as a necessary evil. U.S. Treasury Undersecretary John Taylor made a two-day visit to Buenos Aires in early August and said he was "impressed" by Argentina's new "zero deficit" law. But while Taylor was circumspect about providing any U.S. funding to help Argentina, by late August the Bush administration embraced the old policy of managing international financial crises through new money disbursements by the IMF.

Unfortunately for Secretary O'Neill and Mexican President Vicente Fox, the IMF is almost tapped out. No sooner had the U.S. Congress voted final approval in early August of an emergency $5.5 billion supplemental farm bill than the IMF announced big loans for two of the largest offshore competitors of American farmers. When the Bush administration is eventually forced to go back to Congress seeking additional monies for the IMF, members of both parties may question the logic of additional IMF bailouts in the midst of a recession.

The IMF approved a $15 billion loan to help Brazil fend off the effects of further economic turmoil in neighboring Argentina. The IMF also accelerated disbursement of $1.2 billion for Argentina and released a scheduled $1.5 billion installment on Turkey's $19 billion IMF rescue package. This will take Argentina over $10 billion owed to the IMF, and Brazil up to $8.3 billion owed to the IMF. Significantly, the Brazil credit line will expire in Dec. 2002. Worse yet, if Brazil, Argentina, and Turkey borrow all the money they're allowed to borrow from the IMF, then the IMF will be almost out of cash, unless someone replenishes it. As one former Fed official opined: "We'd all better hope Korea doesn't ask for more new money loans at the same time."

Even with the International Monetary Fund cobbling together another rescue package for Brazil and Argentina, the financial markets have only temporarily been placated. While some battered markets like Colombia and Venezuela actually bounced back during the first half of the year, most experts polled by TIE look for continuing problems in Argentina to affect strong markets such as Mexico's. In this increasingly fluid and dangerous situation, here is the key question: How will the fragile government of Vicente Fox navigate the shoals of a full fledge emerging market financial crisis without the active support of Washington?

Without a clear message from Washington, markets throughout Latin America have fallen sharply under the weight of growing uncertainty in Argentina. Mexico took a big hit in July with the peso falling off its recent peak of almost NP9.0 (new pesos) per dollar, but then quickly rebounded in August. Fears regarding the stability of the government of Fernando de la Rua caused the Mexican peso to back up to NP9.45 in mid July, before rebounding back to NP9.0 per dollar as this issue of TIE went to press. Not surprisingly, the major investment banks are still putting out an optimistic message on Mexican stocks, most recently with Merrill Lynch upgrading its recommendation of number two media company TV Azteca. Yet the fact is that Wall Street is already overweighted in Mexican stocks, which creates the conditions for a significant sell-off later this year.

BBVA Bancomer, in its latest research analysis, says that Mexico slipped into recession in the second quarter off 2001, confirming what every businessman and shopkeeper has known for months. In its monthly report, Bancomer says that Mexico has been in a technical recession since the third quarter of last year. It adds that the worst part of the deceleration is now behind Mexico and that signs of recuperation should appear by the end of 2001. Overall, the Mexican economy lost over 200 thousand jobs in the first quarter of 2001, according to official statistics. Job losses for the second quarter are expected to be larger, and the official figures only capture Mexico's formal sector and ignore the vast underground economy. But it is the sharp contrast between the spreads on Mexican and Argentine debt that tells the story.

In July, S&P and Moody's downgraded Argentina to Band B3 ratings, respectively, just above names such as Ecuador, Cuba, and Pakistan. Yields on short-term Mexican debt were less than 150 basis points above those for U.S. Treasury paper at the end of July, the lowest levels in almost a decade. Even so, the extremely tight spreads on Mexican debt did not prevent investment professionals from London to San Antonio from aggressively buying Mexican assets. Compare Mexican paper, for example, with ten year Argentine Eurobonds, which were yielding about 17 percent in early August, or twelve points over comparable U.S. Treasuries.

The Argentine peso is overvalued because of parity with the dollar, which reached a fifteen-year peak in July on a trade-weighted basis. But the Mexican peso had actually appreciated more than 10 percent against the dollar during the same period, a sharp illustration of the disconnect between Mexico's Bolsa de Valores and the faltering Mexican economy. Significantly, yields on Mexican treasury bills or Cetes have dipped below 10 percent, evidence of Mexico's continuing deflation and strong capital inflows. For example, the cash portion of Citigroup's $12 billion acquisition of Grupo Financiero Banamex-Accival was over $6 billion or about 3 percent of Mexico's GDP, "a significant event for the balance of payments," according to John Welch, a research analyst at Barclays Capital in New York. Welch projects that Mexico's GDP will barely grow one percent in 2001.

Now rated investment grade by both major rating agencies, Mexico trades like a strong AA rated U.S. corporate credit. Argentine debt, on the other hand, is trading at distressed levels, as though the widely expected debt default and currency devaluation were already a fact. Yet Mexico may be more vulnerable than Argentina. While Mexico's economy expanded 6.9 percent in 2000, thanks in large part to booming exports to the United States, this year it is being pinched by a slower economy north of the border that has choked off demand for Mexico's exports.

"The Mexican peso's strength is based on two misperceptions in the marketplace," says Mexico City-based economist Rogelio Ramirez de la O, a respected academician who advises foreign companies and hedge funds operating in Mexico. "The first is that Mexico is a safe haven against turmoil elsewhere in the region. The second: that President Vicente Fox will implement structural reforms."

To the contrary, Ramirez argues, the markets are just starting to see the effects of Argentina's problems on Mexico and other countries, and that Fox lacks the conviction and the political strength to effect the economic reform that the markets expect. Indeed, he reveals that Citigroup had hoped to make its May announcement of the acquisition of Banamex after Fox's tax reform passed the Mexican Congress, but the legislation is now stalled as Fox negotiates a compromise.

Foreign capital inflows and heavy offshore borrowing by Mexican banks and companies, says Ramirez, have set the stage for an abrupt drop in the peso later this year. "There is huge net long exposure to Mexico in the swaps market," he warns, pointing to the end of interest rate reductions in the United States as the catalyst for a weaker peso. Since the election of Fox last July, Mexico has benefited from strong support from international fund managers, many of who are "overweight" in Mexican equities. "September may be last call for the Mexican peso," Ramirez predicts.

"The strong peso and the weak U.S. economy are killing growth" in Mexico, says MIT professor Rudi Dornbusch. "It will take a lot of stability in the United States and sustained Mexican reform to justify the peso's present strength. That can be done but it is not a forgone conclusion. In the meantime, the overvalued currency will hold back growth and, with it, overdue progress in Mexico."

In a June 29 report to clients, Salomon Smith Barney affirmed Mexico as its top pick in the region. But while the notion that the peso is over-valued is still a minority view, investors should remember that periods of high real returns in Latin America are usually followed by long stretches of illiquidity and capital losses. When you see the peso at a four-year high, benchmark Mexican par bonds trading just 150 basis points in yield over U.S. Treasuries, and Cetes offering single digit returns, it may be time to take some money off the table.

While Mexico may have better long-term growth prospects due to the increasing degree of economic synchronicity with the United States and Canada, until Mexico formally dollarizes its economy, an event some think inevitable, the peso will remain the largest single source of risk for offshore investors. Fox calls such talk "alarmist," noting that although the economy is growing at a slower pace, it is still growing, and remains on solid ground. "The reality, friends, is that the economy is marching forward," Fox said in his weekly radio address on July 21. "Take heart, there is no crisis, there is no reason, for the moment, to be afraid."

One way for Fox to address critics regarding the slowdown of the Mexican economy and the prospects for a peso devaluation is to declare the dollar legal tender in Mexico. Significantly, a majority of Fox's own PAN party supports the idea of adopting the dollar and have been outspoken on the subject for several years. In 1999, for example, Senator Arturo Nava of the PAN said the Mexican economy has already been largely dollarized as a result of the frequent use of the U.S. currency in business transactions.

"It's already happening, and the worst of it is that it's being done under the table," he was quoted by the government's Notimex news agency. "There are many companies that already conduct business and issue invoices in dollars, particularly those that export," he said. But, as noted by Rogelio Ramirez, while larger Mexican firms can get dollar financing, most consumers and small businesses must get along with scarce, high-cost peso loans--when they can get them. As in 1994, Mexico's banks and private sector companies are now massively short of dollars and therefore extremely vulnerable to a decline in the peso.

In January of 2001, President Fox said that his country wants a strong relationship with the North American Free Trade Zone, but ruled out adopting the dollar as its currency. Fox said in a speech at the Latin American Chamber of Commerce in Switzerland that he would seek to deepen NAFTA, currently linking the United States, Canada and Mexico. But asked if Mexico would consider dollarizing its economy, he said: "Not in the six years I will be in power."

Sources in Mexico say, however, that Fox understands the argument for Mexico eventually adopting the dollar and actually supports the proposal in principle, but he also realizes that the political backlash following a move to the dollar could be immense. Yet if Washington continues its hands-off policy toward Latin America, Fox may need to reconsider his position on dollarization to differentiate Mexico from Argentina and Brazil.

One possibility would be for Fox to declare the dollar legal tender and leave the peso in circulation, a step that would require no approval from Mexico's legislature or from Washington. If the pundits are right and Mexico does begin to feel a downdraft following a debt default by Argentina, declaring the dollar legal tender would be a very powerful way for President Fox to show that Mexico is really different from the rest of Latin America after all.

           PESOS                    PESOS                    PESOS
DATE      PER US$        DATE      PER US$        DATE      PER US$

1/1/76     0.0125        7/1/77     0.0229        1/1/79     0.0227
2/1/76     0.0125        8/1/77     0.0228        2/1/79     0.0227
3/1/76     0.0125        9/1/77     0.0228        3/1/79     0.0227
4/1/76     0.0125        10/1/77    0.0228        4/1/79     0.0228
5/1/76     0.0125        11/1/77    0.0227        5/1/79     0.0228
6/1/76     0.0125        12/1/77    0.0227        6/1/79     0.0228
7/1/76     0.0125        1/1/78     0.0227        7/1/79     0.0228
8/1/76     0.0125        2/1/78     0.0227        8/1/79     0.0228
9/1/76     0.0194        3/1/78     0.0227        9/1/79     0.0228
10/1/76    0.0208        4/1/78     0.0227        10/1/79    0.0228
11/1/76    0.0243        5/1/78     0.0227        11/1/79    0.0227
12/1/76    0.0203        6/1/78     0.0227        12/1/79    0.0228
1/1/77     0.0209        7/1/78     0.0227        1/1/80     0.0228
2/1/77     0.0225        8/1/78     0.0227        2/1/80     0.0228
3/1/77     0.0226        9/1/78     0.0227        3/1/80     0.0228
4/1/77     0.0226        10/1/78    0.0227        4/1/80     0.0228
5/1/77     0.0227        11/1/78    0.0227        5/1/80     0.0229
6/1/77     0.0228        12/1/78    0.0227        6/1/80     0.0229

           PESOS                    PESOS
DATE      PER US$        DATE      PER US$

7/1/80     0.0230        1/1/82     0.0264
8/1/80     0.0230        2/1/82     0.0322
9/1/80     0.0230        3/1/82     0.0455
10/1/80    0.0230        4/1/82     0.0457
11/1/80    0.0231        5/1/82     0.0465
12/1/80    0.0232        6/1/82     0.0473
1/1/81     0.0233        7/1/82     0.0482
2/1/81     0.0235        8/1/82     0.0695
3/1/81     0.0236        9/1/82     0.0700
4/1/81     0.0239        10/1/82    0.0700
5/1/81     0.0241        11/1/82    0.0700
6/1/81     0.0243        12/1/82    0.0805
7/1/81     0.0245        1/1/83     0.0966
8/1/81     0.0247        2/1/83     0.1024
9/1/81     0.0250        3/1/83     0.1062
10/1/81    0.0253        4/1/83     0.1102
11/1/81    0.0256        5/1/83     0.1142
12/1/81    0.0260        6/1/83     0.1181

           PESOS                    PESOS                  PESOS
DATE      PER US$         DATE     PER US$        DATE    PER US$

7/1/83     0.1221        1/1/85     0.1953        7/1/86     0.5989
8/1/83     0.1261        2/1/85     0.2003        8/1/86     0.6608
9/1/83     0.1301        3/1/85     0.2058        9/1/86     0.7202
10/1/83    0.1341        4/1/85     0.2122        10/1/86    0.7761
11/1/83    0.1380        5/1/85     0.2186        11/1/86    0.8306
12/1/83    0.1420        6/1/85     0.2250        12/1/86    0.8898
1/1/84     0.1460        7/1/85     0.2418        1/1/87     0.9508
2/1/84     0.1499        8/1/85     0.2853        2/1/87     1.0170
3/1/84     0.1538        9/1/85     0.2972        3/1/87     1.0877
4/1/84     0.1578        10/1/85    0.3120        4/1/87     1.1569
5/1/84     0.1617        11/1/85    0.3289        5/1/87     1.2306
6/1/84     0.1657        12/1/85    0.3549        6/1/87     1.3113
7/1/84     0.1697        1/1/86     0.3858        7/1/87     1.3844
8/1/84     0.1737        2/1/86     0.4180        8/1/87     1.4542
9/1/84     0.1777        3/1/86     0.4565        9/1/87     1.5291
10/1/84    0.1816        4/1/86     0.4873        10/1/87    1.6053
11/1/84    0.1856        5/1/86     0.5175        11/1/87    1.6979
12/1/84    0.1900        6/1/86     0.5537        12/1/87    2.0074

           PESOS                    PESOS                  PESOS
DATE      PER US$         DATE     PER US$        DATE    PER US$

1/1/88     2.2124        7/1/89     2.4765        1/1/91     2.9532
2/1/88     2.2479        8/1/89     2.5074        2/1/91     2.9650
3/1/88     2.2809        9/1/89     2.5380        3/1/91     2.9769
4/1/88     2.2810        10/1/89    2.5685        4/1/91     2.9890
5/1/88     2.2810        11/1/89    2.5991        5/1/91     3.0012
6/1/88     2.2810        12/1/89    2.6298        6/1/91     3.0134
7/1/88     2.2810        1/1/90     2.6604        7/1/91     3.0256
8/1/88     2.2810        2/1/90     2.6900        8/1/91     3.0380
9/1/88     2.2810        3/1/90     2.7195        9/1/91     3.0502
10/1/88    2.2810        4/1/90     2.7502        10/1/91    3.0624
11/1/88    2.2810        5/1/90     2.7804        11/1/91    3.0698
12/1/88    2.2810        6/1/90     2.8074        12/1/91    3.0700
1/1/89     2.2954        7/1/90     2.8317        1/1/92     3.0685
2/1/89     2.3249        8/1/90     2.8565        2/1/92     3.0636
3/1/89     2.3547        9/1/90     2.8810        3/1/92     3.0664
4/1/89     2.3851        10/1/90    2.9054        4/1/92     3.0680
5/1/89     2.4155        11/1/90    2.9278        5/1/92     3.0980
6/1/89     2.4459        12/1/90    2.9409        6/1/92     3.1185

           PESOS                    PESOS                    PESOS
DATE      PER US$         DATE     PER US$        DATE      PER US$

7/1/92     3.1165         1/1/94    3.1075        7/1/95     6.1394
8/1/92     3.0913         2/1/94    3.1115        8/1/95     6.1909
9/1/92     3.0862         3/1/94    3.2841        9/1/95     6.3025
10/1/92    3.1185         4/1/94    3.3536        10/1/95    6.6911
11/1/92    3.1198         5/1/94    3.3120        11/1/95    7.6584
12/1/92    3.1182         6/1/94    3.3607        12/1/95    7.6597
1/1/93     3.1100         7/1/94    3.4009        1/1/96     7.5048
2/1/93     3.0989         8/1/94    3.3821        2/1/96     7.5042
3/1/93     3.1083         9/1/94    3.3998        3/1/96     7.5736
4/1/93     3.0955         10/1/94   3.4158        4/1/96     7.4713
5/1/93     3.1227         11/1/94   3.4426        5/1/96     7.4345
6/1/93     3.1213         12/1/94   3.9308        6/1/96     7.5425
7/1/93     3.1236         1/1/95    5.5133        7/1/96     7.6229
8/1/93     3.1126         2/1/95    5.6854        8/1/96     7.5141
9/1/93     3.1127         3/1/95    6.7019        9/1/96     7.5447
10/1/93    3.1142         4/1/95    6.2996        10/1/96    7.6851
11/1/93    3.1553         5/1/95    5.9627        11/1/96    7.9189
12/1/93    3.1077         6/1/95    6.2232        12/1/96    7.8767

           PESOS                    PESOS                    PESOS
DATE      PER US$         DATE     PER US$        DATE      PER US$

1/1/97    7.8299         7/1/98    8.9040         1/1/00     9.4793
2/1/97    7.7926         8/1/98    9.2596         2/1/00     9.4456
3/1/97    7.9628         9/1/98    10.2154        3/1/00     9.2959
4/1/97    7.9037         10/1/98   10.1523        4/1/00     9.3748
5/1/97    7.9057         11/1/98   9.9874         5/1/00     9.5081
6/1/97    7.9465         12/1/98   9.9117         6/1/00     9.7978
7/1/97    7.8857         1/1/99    10.1104        7/1/00     9.4688
8/1/97    7.7843         2/1/99    10.0150        8/1/00     9.2846
9/1/97    7.7792         3/1/99    9.7694         9/1/00     9.3319
10/1/97   7.8114         4/1/99    9.4461         10/1/00    9.5182
11/1/97   8.2837         5/1/99    9.3623         11/1/00    9.5179
12/1/97   8.1360         6/1/99    9.5418         12/1/00    9.4439
1/1/98    8.1798         7/1/99    9.3671         1/1/01     9.7701
2/1/98    8.4932         8/1/99    9,3981         2/1/01     9.7027
3/1/98    8.5689         9/1/99    9.3403         3/1/01     9.6186
4/1/98    8.4996         10/1/99   9.5403         4/1/01     9.3513
5/1/98    8.5612         11/1/99   9.4205         5/1/01     9.1467
6/1/98    8.8948         12/1/99   9.4151         6/1/01     9.0957

Christopher Whalen is a New York-based investment banker and Latin America editor of TIE.