Oct 30 / Victor Arduin

Main factors affecting the Mexican Peso

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Main factors affecting the Mexican Peso

In recent weeks, several regions have seen their currencies depreciate due to the strengthening of the US dollar. Among Latin American economies, the Mexican peso stands out, falling by 1.38% in October and has accumulated a drop of 17.64% over the year, making it one of the most affected emerging currencies. If, on the one hand, the fundamentals of the macroeconomic scenario have brought about an environment of greater risk aversion, strengthening the dollar, on the other hand, domestic factors are also influencing this depreciation and deserve to be highlighted in our analysis.
The days when we saw the Mexican peso appreciate by more than 20% in 2023, the result of increased remittances and a healthy fiscal position, seem a long way off. Other factors, such as direct investments, have also been important. According to the United Nations Conference on Trade and Development (UNCTAD), Mexico received 36 billion dollars, making it the world’s ninth largest recipient of FDI. Mexico, unlike other Latin American countries, does not have such a commodity-oriented trade balance, making these other flows of foreign resources important for supporting its currency.

Now, in 2024, we can see how the Mexican peso has suffered a strong devaluation, compared perhaps only to Brazil. The market has been apprehensive about the country since the election that elected Claudia Sheinbaum , bringing proposals such as changes to the judiciary and a bill to dissolve autonomous bodies proposed by her predecessor President Andrés Manuel López Obrador. While the political scenario creates uncertainty, monetary policy is also not supporting the Mexican peso. In September, the Bank of Mexico (Banxico) made its third interest rate cut this year, reducing the rate by 25 basis points to 10.50%.

Image 1: Performance of Selected Latin American Currencies (annual variation, %)

Source: Refinitiv

In the external environment, the current winds are not favorable either. Although the US interest rate cut in September weakened the dollar and strengthened currencies globally, in October these gains were reversed, with the Mexican peso depreciating by more than 1.5%. However, it is the domestic factors that are weighing most the currency's devaluation. Our fair value model for the Mexican peso helps to understand this dynamic.

The model consists of capturing the volatility of a basket of currencies from emerging countries, nations that share, at some level, economic and institutional characteristics with Mexico; reducing the dimensionality of the exchange rates by means of a principal component analysis and reproducing the value in a time series of the Mexican peso. The result is the exchange rate that would be observed in the country if internal factors did not affect (positively or negatively) the exchange rate identified in the graph as MXN (Emerging).

Image 2: Fair Value Model for the Mexican Peso (USD/MXN)

Source: Bloomberg

In some months of 2022 and 2023 , the Mexican peso appreciated against our model, due to the appreciation mentioned above. However, we can see that at the end of May this year, the country's currency began to depreciate sharply. Without domestic fears, the currency could be at 16.812, around 16% lower than its current value.

With the US elections approaching, the Mexican peso might face several more weeks of strong pressure. Protectionist trade policies from the US could reduce direct investment in the country, as well as increasing tariffs on products produced in Mexico. Former President Trump's promise of tax cuts could impact the country's high fiscal deficit, resulting in higher premiums on US treasuries and support for the dollar.

The current situation brings with it a lot of noise and volatility. As long as market aversion to the new set of policies being implemented in Mexico persists, as well as uncertainty about the impact of the US elections on the country, the natural tendency will be for the Mexican peso to depreciate.
Written by Victor Arduin
victor.arduin@hedgepointglobal.com
Reviewed by Laleska Moda
laleska.moda@hedgepointglobal.com
www.hedgepointglobal.com

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