We've certainly seen worse: struggling peso shows signs of stabilizing, while inflation and interest rates remain manageable. (Economic Report).

Every year presents its challenges to businesspeople and 2003 is no exception. Uncertainty has always been an issue but, this year, the nature of the uncertainty is different.

One major change and a sign of Mexico's progress is the question that plagued businesspeople (and everyone who lived in Mexico) for decades--"Will there be a maxi-devaluation?"--is not being batted around. The government no longer determines the cost of a dollar and reserves are at historic levels, roughly triple the expected current account deficit and more than double the money in circulation.

We've seen the peso appreciate as well as depreciate, a prediction that would have prompted laughter if made eight years ago. And, within the last year, on two occasions, the peso has depreciated a noticeable percentage (over 10%) in the space of a month without wreaking havoc. So, what was for a quarter of a century probably the greatest fear of most businesspeople needn't be a source of concern today.

Even though the peso has depreciated rapidly against the dollar since the closing days of 2002 (about 9% between late December and the first week of March), there hasn't been a panic. Neither has the government intervened to support the currency. Although the governor of the central bank has indicated his desire to intervene, the finance secretary, who has the deciding vote on the Exchange Commission that determines exchange rate policy, ruled out intervention. With the peso having depreciated about 20% against the dollar over the course of 11 months, the strong peso that plagued exporters or domestic producers who compete against imported goods for the last three years has been put to rest.

Will the peso continue to fall against the dollar? The peso should not be 20% weaker at year-end than it was in early March. When the cost of a dollar first began its ascent from under Ps$ 10.2 in mid-December to around Ps $11.0 a month later, expectations were that because trading volumes were low, the peso would appreciate.

When exchange rates move in thin markets, the odds of "overshooting" or "undershooting" the level at which a currency price eventually stabilizes are higher. However, as the days go by and the cost of a dollar remains stubbornly hovering around Ps$11.0, it appears that the exchange rate is finally moving to a level more in line with what purchasing power parity calculations suggest is appropriate.

In the past, the peso has moved along with oil prices. Given that oil provides a little less than a tenth of Mexico's substantial US$160 billion in export revenues, it's easy to understand why the peso might rise and fall with the ups and downs of petroleum prices. That relationship isn't holding this year. The average price of a barrel of Mexican export crude was over US$22 in the second quarter of 2002, almost a third higher than in the first quarter. In the second half of last year, the average price was over US$23. When the peso began its slide in December, oil prices were higher still.

Lately, the best predictor of how the peso will move is how the dollar fares against the euro and the yen. When the dollar depreciates against those currencies, the peso depreciates against the dollar. Why that should be isn't obvious. Until the transmission mechanism is established, it's best to bear in mind that correlation is not necessarily causation and that the role of psychology in markets should not be underestimated.

EYEING INFLATION

Inflation is another longstanding problem that won't be a problem in 2003. Inflation did pop back up last year: at 5.7%, it was more than a quarter higher than the objective and the 2001 inflation rate. After three consecutive years of accomplishing what very recently seemed impossible--an inflation rate below the target rate--tradition reasserted its primacy and inflation accelerated.

The principal reason inflation rose was the trajectory of public sector prices. Administered prices soared 16.8% last year, nearly three times the increase in the consumer price index and more than four times the 3.8% rise in underlying inflation. Contributing to inflation were higher prices for education and training (+10.0%) and agricultural products (+8.7%), but even if education and agricultural prices had risen at the same rate as the consumer price index, inflation would still have been 5.1%.

This year, the Finance Secretariat has stated the average increase in public sector prices will be 2.7%. Technically, that doesn't rule out reducing subsidies the government grants users if public sector revenues fall too far short of budget. However, in mid-February, with oil prices sufficiently high to cause OPEC to raise its output and a third of Mexico's public revenues dependent on oil, it doesn't look like the Finance Secretariat will have to choose between inflation and meeting the budget deficit target of 0.5% of GDP this year.

Administered prices and the cost of fruits and vegetables were the attention grabbers in the 2002 inflation figures, but there's another issue that must also be addressed if the battle against inflation is to be definitively won. The strength of the peso has been critical to bringing the underlying inflation rate to last year's 3.8%. The cost of merchandise, which typically must compete against imports, rose 1.9% in 2002. The cost of services, which typically don't face import competition, rose 6.4%. In its last two increases of the "short" on Jan. 10 and Feb. 7, the Banco de Mexico explicitly cited the growth of services' prices as a concern, arguing that wage increases must be kept within the "inflation plus productivity gains" formula. That should be possible this year.

Last year saw companies break through the psychologically significant barrier and give single-digit wage increases. Although inflation rose, the slow economy and emphasis on increasing productivity and profits, which included controlling staff size, put more emphasis on preserving employment than wage increases in negotiations. AMCHAM doesn't expect that to change this year. The problem, if there is one, will be with the wage increases granted politically savvy, powerful public sector unions.

Inflation of around 5% is an impressive accomplishment for Mexico. While success can't be taken for granted and the fight to keep inflation coming down shouldn't be abandoned, AMCHAM does not expect it to be a serious threat.

INTEREST RATES

Neither will the level of interest rates be a major problem. AMCHAM expects interest rates, both nominal and real, to be higher than last year, but by historic standards, both will be quite low. The beginning of this year already saw rates rise: the nominal one-month Cete rate, which averaged 7.0% in December, rose to 9.6% in the first auction of March. Historically, the real (discounting inflation) interest rate in pesos has run around 5%. Last year, the real rate dropped to roughly half that. Mexican risk has diminished, but that's an extremely low risk premium. Perceptions of risk everywhere in the world have heightened and interest rates and premiums must reflect that.

The level of interest rates has not been the obstacle blocking the flow of credit to the private sector. Neither will it be this year. There are several other reasons why commercial bank credit to the private sector (excluding restructured loans) in real terms is a risible third of its 1994 levels. The difficulties in securing loans and taking collateral is one reason. Another is the ease of making money by lending to the government as the gap narrows between the rates banks earn by investing in Cetes, Bondes, IPAB bonds and other government instruments and what they pay depositors, it creates a subtle incentive to lend to the private sector. "No risk, sure return" is a hard formula to beat.

That there's plenty of money in fees for services has helped banks to be profitable without venturing too far into the riskier area of lending. Coupled with the trend, international as well as in Mexico, for non-banking financial entities to play an increasingly more important role in lending, don't look for commercial bank lending to private businesses to pick up.

It's not new for Mexico's economy to be buffeted by adverse developments abroad. In the past, it's typically been a drop in oil prices that has caused problems. This time around, it's the fear of war and its consequences, the drop in the growth rate of the U.S. economy below its potential, the deflation of equity markets, the depreciation of the dollar against the euro and yen and the rise of China as a manufacturing powerhouse.

Further structural reforms would help Mexico weather the uncertainty and complicated international environment. Those are virtually precluded before the congressional elections in July. Depending on the outcome of those elections, the possibility of reform may improve, but don't count on any major steps forward.

Failing additional reforms, the nation's economic prospects through the rest of the sexenio are for macro-stability, relative to Mexico's past, and slow growth. Intense competition and weak demand will keep margins under pressure. It's a different set of challenges than those presented by the tradition of macro-devaluations and hyper-inflation, but challenges that, to a greater or lesser degree, businesspeople have been facing. This year won't be an easy year for businesspeople but, in the end, few are.

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Dr. Deborah L Riner is the chief economist at the AMERICAN CHAMBER OF COMMERCE OF MEXICO.