Mexico Boosts Peso Defense With Shock Rate Hike, Budget Cuts

February 23, 2016

  • Carstens announces 50bps increase to benchmark lending rate
  • Finance minister announces 132.3 billion pesos in reductions

Mexico jolted investors with a pair of surprise moves aimed at stemming the rout in the peso and preventing inflation from taking hold in Latin America’s second-largest economy.

In a rare coordinated announcement Wednesday, central bank Governor Agustin Carstens and Finance Minister Luis Videgaray said borrowing costs will increase 0.5 percentage point to 3.75 percent as they cited the risk that the peso’s depreciation would fuel inflation. The surprise move comes after Mexican assets were swept up in a global rout fueled by a plunge in oil. Crude’s drop has forced the country to cut spending for two straight years.

The peso surged the most since 2011 after the rate increase and as the central bank also said it would replace its daily dollar-auction program with a plan to sell greenbacks directly to banks whenever needed to support the currency. The peso jumped 3.4 percent, the most among the world’s most-traded currencies, to 18.2558 per dollar at 2:35 p.m. in New York, after reaching a record 19.4448 on Feb. 11.

The measures are “very aggressive,” said Marco Oviedo, the chief Mexico economist at Barclays Plc, who said this is the first time Banxico has raised rates in a surprise meeting. “The peso may stabilize, but rate increases should continue if it doesn’t.”

The government will also cut spending this year by 132.3 billion pesos ($7.25 billion), or 0.7 percent of gross domestic product, from the level approved by lawmakers in November, Videgaray said. From that amount, 100 billion pesos will come from state-owned Petroleos Mexicanos. The oil producer’s board still need to approve the figures, he said.

The oil rout “affected public finances and the current accounts,” the central bank said in a statement accompanying its rate decision. “That’s had a negative impact on the price of the national currency, increasing the probability that inflation expectations will arise that aren’t in line with consolidating a permanent target of 3 percent.”

Carstens had warned this month that the central bank would have to raise rates far more if the government didn’t cut spending, especially at Pemex, to reflect a lower revenue scenario.

Long Shadow

While Mexico’s economy is still poised to expand 2.8 percent this year, according to the forecasts of economists surveyed by Bloomberg, a growing budget deficit and weaker currency are casting a shadow amid concern that inflation will accelerate.

Oil-producing nations across the world are facing pressure from low crude prices. On Tuesday, Standard & Poor’s cut the outlook for Colombia’s credit rating, citing a worsening growth outlook due to the oil rout.

Mexico’s peso, the most-traded emerging-market currency, has repeatedly plunged to new record lows this year. Traders often use the peso to hedge against other risks because it trades all day, has high volume and is cheap to borrow. For that reason, it ends up being more vulnerable to swings when investors flee riskier assets.

Wednesday’s announcement is welcome news to foreign investors who have seen the peso’s tumble eat into dollar-based returns. The currency’s loss meant that Mexico’s fixed-rate government peso bonds, 60 percent of which are owned by foreigners, had lost 6.6 percent in dollar terms this year through Tuesday, according to Bank of America Corp. indexes. The benchmark stock index’s 0.8 percent gain this year changes into a 5.1 percent loss when taking into account the currency fluctuation.

“They are doing the right thing,” Pablo Cisilino, who helps manage about $42
billion in emerging-market debt at Stone Harbor Investment Partners LP in New York and says he’s been adding to his exposure to the peso and Pemex credit recently, said in an e-mail. “Mexico is showing strong capacity to react to negative external shocks.”

President Enrique Pena Nieto appointed Jose Antonio Gonzalez Anaya as Pemex’s new chief executive officer last week, saying the task at hand for new head of the state-owned oil company will be to “achieve financial and productive strengthening at a time of low oil prices.” It will be necessary for Pemex, which has reported 12 straight quarterly losses and is saddled with record debt, “to adjust its cost structure and review its expense program,” Pena Nieto said.