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Another Peso Disaster May Be Waiting In The Wings

Economic Viewpoint


You'd think that the 1994 economic crisis would have taught Mexican policymakers a lesson: Stay far away from currency overvaluation or risk financial meltdown. But no. The same strategy that led to that disaster is being used again. Instead of being allowed to float lower, the peso is being held artificially high to attract foreign capital and combat high inflation.

If market forces had their sway, a country with high inflation would see its currency depreciate. Otherwise, the country would become uncompetitive in world markets, export growth would slow, and imports would explode. Foreign trade would then become a drag on growth. This is precisely what happened to Mexico last time, and it is happening again today.

By conventional purchasing-power parity measures, Mexico's competitiveness today is only about 20% better than in 1993. Over the past year and a half, its competitiveness has been shrinking rapidly. Indeed, it is barely enough to keep the economy expanding. It is definitely not sufficient to spark high growth and job creation.

Why can't Mexican authorities keep their country competitive by allowing the peso to depreciate at the pace of inflation? One answer is that an overvalued currency attracts foreign capital. Mexico's industries may be going under from loss of competitiveness, but its bonds are popular because of high interest rates set by the Bank of Mexico. The result is a cycle of high interest rates, imports of capital, and further overvaluation of the peso. The ensuing erosion of competition then gnaws at economic growth and employment.

OBSESSIVE. It would be better to be less obsessive about fighting inflation and to seek long-term solutions to generating domestic capital. Why is this so hard for policymakers to accept, especially given Mexico's recent disastrous experience?

There is a second reason for the high-peso strategy. An overvalued peso lowers import costs, thus slowing inflationary pressures. With inflation in check, workers will accept slower increases in wages, again curbing inflationary forces. From a perspective of inflation fighting, holding the exchange rate works. But this seemingly virtuous cycle hurts international competitiveness and trade. An overvalued peso means that Mexican exports become increasingly expensive and imports get cheaper. This is what has been happening over the past year. The trade advantage from the 100% devaluation of the peso in 1994 and 1995 has been dissipating month by month. Mexico's big trade surplus is beginning to shrink fast and will soon disappear.

A third reason for a high-peso strategy focuses on financial balance sheets. Mexican banks are the walking wounded, and corporations are not much better. The best cure for both of them is low interest rates. But how can an open, high-inflation economy such as Mexico's have low rates? The answer is to have rates that are moderate relative to Mexican inflation. That means relatively high nominal rates but zero real rates. That still gives Wall Street returns of 25% until further notice and allows Mexico to start growing again.

HALF-BAKED. Mexico's central bank has demonized inflation to a point where it cannot cut loose from its own rhetoric. There is plenty of evidence that extreme inflation--20% per month--is devastating for growth. But more relevant, is the overwhelming support for the contention that moderate inflation of, say, 20% per year does not interfere with growth. True, it would be better to have none. True, it should be brought down over time. But it is not the single overriding issue. Growth, jobs, and political stability are just as important, and they do not thrive when competitiveness is sacrificed for balance-sheet manicures.

So Mexicans wait for their overvalued peso "to be hit again" in the foreign-exchange markets while the internal policy debate revolves around half-baked ideas about credibility. The prospects for strong growth are bleak. The standard line of central bankers and hard-money gurus--zero inflation is the only stable inflation--is just not true. Countries with moderate inflation around the world have managed to achieve gradual reductions without either compromising the credibility of that strategy or sacrificing growth. Countries such as Finland, Japan, and Switzerland, which took the zero-inflation propaganda too seriously, are now flat on their backs. Mexico must cut loose from the fiction and get back to life. It's time for Mexico to have a new team in the central bank. The present crew shows no signs of learning from the past, understanding the present, or preparing for the future.BY RUDI DORNBUSCH

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