Putting The Peso On A Short Leash

The time has come for Mexico to consider adopting a currency board. Despite an unprecedented $53 billion financial aid package, the monetary credibility of the government continues to erode. The big victory of the conservative National Action Party (PAN) in Jalisco Province and the failure to capture the leader of the Chiapas rebellion are raising doubts about the political as well as economic leadership of President Ernesto Zedillo Ponce de Leon. His ability to enforce harsh anti-inflation policies on a restive public in the face of a sharp 40% devaluation is now being sharply questioned by the markets. The peso is weakening again, short-term interest rates on tesobonos are moving higher, and the bolsa is sinking. Weeks after the bailout was announced, the confidence necessary to revitalize private capital flows to Mexico isn't being restored. A dramatic new gesture is needed.

Enter the currency board. Argentina, Estonia, and Hong Kong have used currency boards to successfully establish effective monetary anchors to force hard domestic political decisions on economic policy and revive foreign investor confidence. Mexico should follow suit. Its central bank has zero credibility in world financial markets following disclosures that it hid the decline of reserves and the expansion of bank credit in the months before the peso devaluation.

How would a currency board work? The peso would be fixed and made fully convertible to the dollar at, say, 51/4 to 1. The monetary base (bank reserves and currency) would, in turn, be backed 100% by hard foreign currencies, mostly dollars. This would take about $10 billion. Money could then be created only by increasing these reserves. For every extra dollar generated through net exports or capital inflows, five and a quarter new pesos could be generated. If Mexico adopted this kind of currency board, it would, in effect, be tying its inflation rate and interest rates to the U.S. The Mexican government and the central bank would give up all discretionary power to pump up the money supply or to act as lender of last resort.

A Mexican currency board would broaden the economic integration that began with the North American Free Trade Agreement to include monetary policy. While the value of the peso would be guaranteed vis-a-vis the dollar, internal prices would fluctuate. The PACTO, the annual agreement on wages and prices, would have to be abolished. And state-owned assets would have to be sold off to the private sector to sop up excess pesos.

If all that sounds a bit like currency integration for Mexico, Canada, and the U.S., so be it. The North American Three flirted briefly with this idea during NAFTA discussions but dismissed it as politically unfeasible. A currency board for Mexico may be the next best thing. A hard-money, deflationary bias would be automatically built into Mexican economic policy. That would restore monetary credibility, encourage capital inflows, lower interest rates, and boost economic growth. Mexico has to act fast to prevent its liquidity crisis from becoming a solvency crisis for its banks and corporations. A currency board is an option of last resort. But without confidence, even $53 billion will go pretty quickly.