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The Lessons of Mexico Vs. Europe

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Mexico's depreciating currency and stable interest rates have done it well.

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Many of Europe's problems come into better focus if, as I suggested most recently in Revisiting the Cost of Being Europe, if the eurozone is viewed as 17 different countries that fixed all of their exchange rates against one another. As a country can fix an exchange rate or its short-term interest rates, but not both, the currency union is characterized by widely fluctuating interest rates.

Now let's take our neighbor to the south. For much of its history, Mexico tried to preserve its peso exchange rate via higher short-term interest rates; it generally failed after a point only to watch the MXN collapse and short-term interest rates surge in a vain attempt to keep capital in the country.

Mexico took a different approach within its free-trade zone. It allowed the MXN to depreciate and resisted the temptation to raise short-term interest rates. The interest rate gap between three-month MXN and USD has been stable for almost two and one-half years and has remained so through both a sharp rally in the peso between March 2009 and August 2011 and the subsequent decline.



The August 2011 turnaround, highlighted on the chart above, is no accident. This is the date when our beloved Federal Reserve announced to the world that it would keep short-term interest rates near 0% into 2013. Several major emerging markets, all of which had been on the receiving end of the dollar carry trade, faced the prospects of an American QE3-style policy flooding their economies with cheap cash and creating both asset bubbles and higher inflationary pressures. I will address India's approach in a later column.

Suffice to say, had Mexico raised domestic interest rates, the carry trade cash would have created problems. Instead, it kept its rates under control and allowed the peso to decline. In keeping with my oft-stated principle that equity markets do not care whether a currency is "strong" or "weak" but only whether it is valued fairly, Mexican stocks held their own vis-à-vis their American counterparts.



The combination of a weaker peso and a more stable U.S. economy helped remittances rise in 2011 over 2010 levels. Mexico exports labor, a euphemism, and imports capital from their earnings to support domestic consumption; remittances actually are Mexico's second-largest source of foreign exchange.

Here is where the comparison to Europe becomes obvious: A Mexican worker receiving dollars and buying pesos can do something a Spanish or Portuguese worker in Germany cannot do, and that is swap a strong currency for a weaker one. If the weaker countries of the eurozone export labor, those workers cannot turn around and buy ever-larger quantities of pesetas or escudos; no, they are buying a singly valued euro.

As long as the common currency remains with us, weaker eurozone members will lose their mobile labor force to stronger ones and suffer a net welfare loss. This is really a damning argument against the euro. The sad part is, getting from here to there will involve a number of adjustment shocks, and that, too, is a euphemism.

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No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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