The Mexican peso (MXN) ranks as the 8th most traded currency in the world and the 3rd in the Western Hemisphere, behind the US dollar (USD) and Canadian dollar (CAD). MXN crosses with USD attract fewer participants than do major pairs, including the Euro (EUR/USD) and yen (USD/JPY), but the currency still offers highly liquid access to Latin America, as well as opportunities created by emerging market growth and weakness.
MXN has transformed from a sleepy developing world currency into an international financial instrument in recent decades. (See also: Emerging Markets: Analyzing Mexico's GDP.) While forex trading has also boomed worldwide during this period, three specific catalysts have driven the majority of the currency’s rapid growth. Let’s examine these macro forces and look at major challenges that could undermine peso liquidity in coming years.
1. Crude Oil
As the 9th largest oil producer in the world, Mexico ties its currency to energy prices because its vast reserves provide collateral for borrowing that translates into government spending programs. International lenders are more willing to take risk in petroleum-dominated countries when crude oil prices are high, translating into lower borrowing costs. This generated an economic boom throughout Latin America when crude oil hit an all-time high in the middle of the last decade.
Oil production accounts for more than 10% of the country’s export revenue, intensifying currency swings when crude oil is moving sharply higher or lower. In addition, the government collects high tax levies on Pemex, the state-owned oil giant, accounting for nearly one-third of all taxes collected in the country. This significantly adds to MXN’s dependence on energy prices.
As a non-member oil producer, Mexico has been hit hard by an OPEC supply build up, adding to pressure created by a multiyear decline in oil production. While new reserves suggest the tide may turn and support an increase in output that will underpin the value of its currency, challenges from the flight of emerging markets could cancel out those gains. (See also: Is Mexico an emerging market economy?)
2. Proximity with United States
Mexico and the United States hold a long border and special relationship that extends into broad trade agreements and chronic political discord, generated by immigration and drug trafficking. Physical proximity generates an additional effect on the peso’s value, with highly populated border regions engaging in vast commercial interactions that add significantly to MXN liquidity while forcing continuous resets on the relative value of the currency compared to the U.S. dollar.
The USD/MXN forex pair offers the natural Mexico-USA currency play and is also the most liquid MXN pair. The United States exported $240 billion in goods to Mexico in 2014 while importing $294 billion, adding significant liquidity. This Balance of Trade (BOT) shows great fluctuation in the last decade, with the shifting ratio having an impact on relative value. MXN has been on the losing end of this equation, falling relative to USD for more than 20-years.
3. Central Banks and the Hunt for High Yield
Central Bank stimulus after the 2008 economic collapse, starting with the first round of quantitative easing (QE) in the U.S. in March 2009, lowered yields on bond instruments in first-world economic centers, including the United States and Eurozone. Hot money funds responded by turning their attention to emerging markets and third-world countries where higher yields equated into higher profits. This is commonly known as the carry trade.
This imbalance triggered a multiyear surge of capital into emerging markets, including Mexico and Latin America. At the same time, China industrial growth exploded, increasing demand for commodities that added further liquidity to currencies in these venues, including MXN. These forces combined to trigger an historic growth spurt south of the U.S. border.
Challenges in Coming Years
Falling crude oil and commodity prices have undermined Mexico’s growth while oil production continues to decline, doubling the downside effect. This has contributed to an historic collapse in the peso compared to the U.S. dollar and euro. In turn, this is dampening MXN liquidity at the same time that capital flows have reversed, with hot money exiting Latin American economies.
Meanwhile, U.S. quantitative easing has come to an end, with bond yields coming off multi-decade lows, encouraging capital to return to local venues. Continued strengthening in the U.S. dollar is adding to the exodus, which has the power to suck liquidity out of the peso in future years. Mexico has attempted to stem the tide by selling U.S. dollars, but the policy is having limited impact.
Mexico’s corporations have added to the liquidity challenge because they’ve borrowing heavily in U.S. dollars, which are cheaper than local currency. This has raised debt levels significantly in recent years, with servicing costs rising due to the peso’s decline. This removes tranches of capital that could have been allocated to products and services, in turn underpinning the currency’s liquidity.
The Bottom Line
The Mexican peso shows high liquidity for three reasons. First, it has vast crude oil reserves that contribute to international trade. Second, the country's physical proximity with the United States encourages billions of dollars in commercial activity. Third, it attracts international capital due to higher yields than found in first-world nations.
