The finance ministry and Bank of Mexico (BoM) announced on February 17 an end to the rules-based intervention ($200mn sales when MXN depreciated by 1% and another $200mn when MXN depreciated further 1.5%) which has already cost about $20bn (around 11%) of foreign exchange reserves over the last year. The central bank will sell USD on a random basis and will not report daily USD sales, presumably to keep speculators at bay. Use of the FCL (flexible credit line) from the IMF to reinforce reserves will be a tool of last resort and is not being used at this time. Bank of Mexico was selling USD in the market this week ahead of the press conference and outside of the rules-based intervention. MXN strengthened by about 3% on Wednesday after the announcement. Also, the central bank announced an extraordinary hike of 50bps to the policy rate, to 3.75%. The previous monetary policy meeting was just a couple of weeks ago on February 4 and the next scheduled meeting is on March 18. However, the BoM president indicated that the recent move is not the beginning of a tightening cycle.
Also, the finance ministry announced MXN 132.3bn in budget cuts worth about 0.7% of GDP, including MXN 100bn in spending cuts in Petroleos Mexicanos (PEMEX) worth about 0.5% of GDP in view of the current oil market situation. Therefore, three-fourths of the budget cuts will be related to PEMEX spending and the rest will be in current spending (60% of the remainder) and investment spending (40% of the remainder). The finance minister indicated that a capital injection to the company may be forthcoming in the next few weeks and will depend on the oil company’s business plan. These may include asset sales (which we believe would not amount to more than $1-2bn/yr). Funds for this capital injection may come from the surplus the government generates from its operations with the central bank.
Overall, these are very important announcements and signal a more activist approach to foreign exchange policy and a consistent desire to keep fiscal accounts under control. MXN had depreciated more than 10% since the beginning of the year before these announcements, making it one of the worst performing EM currencies, together with RUB and ARS. The authorities are clearly aware of the political impact of the runaway MXN depreciation as well as the pass-through effect on inflation. Although inflation is still close to the 3% mid-target band, a change to a new CPI in H216 will make domestic prices more vulnerable to currency depreciation. Although Mexico has benefited from export price competitiveness generated by the weak peso, the exaggerated depreciation was worsening business expectations. The policy rate hike and budget cuts may have a negative impact on growth, but will reinforce the country’s attachment to policy orthodoxy and help to sustain its current sovereign ratings (A3/BBB+/BBB+), despite potential downgrades to PEMEX.
We believe growth will suffer from these measures if there is not a material rebound in global/oil conditions. We expect MXN to begin trading in a narrower band, but because of fundamentals and our global/oil view, we do not think MXN will be able to strengthen and stabilize at significantly lower levels from 18.0/USD. Not surprisingly, the Mbono (peso-denominated debt yields) curve has flattened after the announcement. On the credit side, these measures are credit-positive for the sovereign but we do not believe they will be sufficient to produce a rally given current spreads and ongoing global/oil uncertainties.
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