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The Problem With Predicting Exchange Rates

Topics: Money

Published: Sunday, January 8, 2012

Exchange Rates

In recent years, one of the hardest things to predict has been the peso/dollar exchange rate. Just when the peso seemed to be making a comeback from the 2008 devaluation, something else has happened leading  investors to move back into dollars, either buying US Treasury bonds as a safe place to park money, despite very small returns, or buying dollar contracts in futures markets to protect their foreign investments against depreciation of the currencies in which they have invested.

As a consequence, in the last three years, the dollar has been anywhere between 11.50 and 14 pesos, including a brief period when it went as high as 15 pesos or more. At the end of 2011, the dollar was at 13.97 pesos.

The weaker peso has its advantages and disadvantages. To begin with, it makes Mexico’s exports relatively cheaper, and therefore more competitiive in the international market. Similarly, it makes vacationing in Mexico a more attractive option. Even though hotels and airfares are generally quoted in dollars, other costs of travel such as food, souvenirs and other goods bought locally are cheaper in dollar terms. For people with peso incomes, particularly those who travel frequently to the US or who buy a lot of imported goods,  the depreciation of the currency is a definite disadvantage.

One thing that has changed in the past 15 years or so, is that currency depreciation hasn’t been reflected in high inflation in Mexico. In earlier decades, when the currency was controlled at a certain level until it became unsustainable and a devaluation was necessary, an immediate reaction in Mexico would be to put up the prices of goods and services even if they weren’t directly associated with the dollar–local rents for example. This general knee-jerk reaction, with the excuse that “es que subíó el dólar,” would be reflected in general inflation, pushing up the cost of living for everyone.

This exchange rate effect has diminished significantly in more recent times, and a higher dollar will only add to the cost of things such as imported goods, and products that require imported components.  Inflation was less than 4% in 2011, and is widely expected to stay below 4% in 2012. (In 2008, when the peso went from 10 to 13 to the dollar, inflation rose to 6.5%).

The frequent and often sharp moves in the exchange rate can also create some difficulty in budgeting when expense planning involves two or more currencies. It would be nice to know what sort of exchange rate to expect.

And that is where there really isn’t a great deal of help forthcoming. Based on what economists call fundamentals – the country’s debt payments as a percentage of GDP, its trade balance (Mexico tends to have very small trade deficits), the rate of inflation, economic growth, etc – the peso should theoretically recover against the dollar this year. Nevertheless, any blowout in Europe, such as a debt default by one or more countries, one or more countries abandoning the euro, or the – very unlikely – breakup of the euro, would again cause investors to rush for the safe bets, such as the U.S. dollar. This would almost inevitably have an effect on the peso which as an emerging-market currency would be included in any emerging market selloff.

The difference between now and 2008, though, is that the cause of the crisis would be Europe and not the US, and Mexico’s economic fortunes are much more closely tied to the US and its economy.

The Bank of Mexico keeps regular track of what economists are expecting the peso to do. The most recent survey published in mid-December showed that they expect the currency to end 2012 at 13.15. That estimate changes though, from month to month.

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