The Sickly Peso Could Give Mexico a Nasty Cold

Economists worry that it may boost rates and stifle growth

Last year, it was the bull of the money markets. Even as virtually every other currency around the world was losing ground against the dollar, the Mexican peso not only remained strong but gained value against its northern neighbor's currency. Now, as the dollar has drooped, so has the peso, shedding 5% of its value in January alone. The exchange rate is now hovering near 11 pesos to the dollar, a 20% decline from a year ago. While Mexican exporters are cheering, economists are worried that the slippage will stoke inflation, drive up interest rates, and stifle economic growth.

No one is predicting a peso crash, à la 1994. Mexico's currency is less susceptible to abrupt devaluations now that it floats freely, and government finances are more transparent. Indeed, Central Bank Governor Guillermo Ortiz insists the peso's current weakness marks no more than a spell of turbulence. He points out that Mexico attracts a steady stream of dollars thanks to high oil prices, and that it has $48 billion in hard currency reserves with which to fight off any speculative attack. Ortiz' main concern is that a weaker peso will undermine his goal of holding inflation at 3% in 2003. That's why on Jan. 10 he moved to tighten the money supply, thereby forcing up interest rates.

Independent economists aren't so sanguine. They are betting that the peso will tumble further, especially if the U.S. economy remains sluggish. Mexico's exports to the U.S. account for roughly one-quarter of its gross domestic product, so Wall Street has been revising its Mexico forecasts downward to reflect a feeble recovery in the U.S. Merrill Lynch & Co. recently pared its estimate for annual GDP growth from 3.4% to 2.9%, and expects the peso to touch 11.15 pesos to the dollar by June. Merrill's chief foreign exchange strategist, Yiano Kontopoulos, argues that interest rate hikes alone won't bolster the peso. "Mexico has accumulated a substantial amount of foreign reserves and should have the willingness and capacity to intervene [in foreign exchange markets]," he says.

The peso's slide should be a wake-up call for Mexican politicians. Legislators are dragging their feet on critical initiatives, such as the opening of the country's highly-protected electricity and gas sectors, that would make the economy more attractive to foreign investors. "Investors are concluding there won't be any structural reforms this year, and that is taking away some of the enthusiasm for Mexico," says economist Jonathan Heath of consultancy LatinSource.

Of course, a cheaper peso could also be good for Mexico, if it makes its goods more competitive vis-a-vis that other export powerhouse, China. Mexican shipments to the U.S. surged with the advent of NAFTA in 1994. But they edged up only 1.2% last year, according to Merrill Lynch estimates, compared with a 19% jump for China. "Mexico once thought it had unique, unbeatable competitive advantages, but they have been whittled away," says Christian Stracke, head of emerging-markets research at CreditSights Inc., an independent research firm in New York.

Officials are watching closely to guard against an inflation-inducing peso rout. If they're lucky, a weaker currency will just give Mexico some traction in its fight to hold onto its global customers.

By Geri Smith in Mexico City

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