Living, Money

The Problem with Predicting Exchange Rates

USD MXN Exchange Rates

In recent years, one of the hardest things to predict has been the Mexican peso/US dollar exchange rate. Mexico’s peso is a free-floating currency on world foreign exchange markets; it’s among the world’s top-10 most-traded currencies, and is the most-traded of Latin America’s currencies.

At first glance, 2018 was a volatile one for the peso-dollar exchange rate, which saw its fair share of ups and downs. The peso’s strongest close against the U.S. dollar was $17.99 in April, and its weakest point was $20.83 in June—just before the presidential elections in Mexico.

But taken for the year as a whole, the exchange rate was fairly stable, more so than in 2016 and 2017 when tensions with the U.S. under President Donald Trump had sent the peso to an all-time low of $22 to the dollar at one point.

The exchange rate averaged $19.24 pesos to the dollar in 2018 compared with $18.91 in 2017, and ended the year at $19.66, the same as 2017.

The main reasons for the swings in the exchange rate were the June elections in Mexico and the jumpy progress in trade negotiations with the United States, which ended over the summer in an accord to make changes to the North American Free Trade Agreement and rename it USMCA — the U.S. Mexico Canada Agreement — as Trump wanted. Mexico, which called NAFTA “TLCAN” in Spanish, has decided to call the new agreement T-MEC.

The Mexican elections came before the trade deal, with nationalist Andrés Manuel López Obrador winning with a clear majority in a field of four candidates. Market participants have been hot and cold about the new president. His pledges to respect the autonomy of the central bank — and his choice of members to join the central bank’s board of governors — were well received, as was the 2019 federal budget which keeps a lid on government debt. On the other hand, when he decided at the end of October to cancel the Mexico City’s new airport, which is already partly built, the peso suffered some dips, and concerns remain about his government’s nationalist energy policies.

Inflation in Mexico was more helpful for the peso last year than in 2017. The consumer price index ended the year up 4.8% compared with a 6.8% rise the year before. Additionally, the Bank of Mexico raised interest rates several times to 8.25%, which makes it more attractive for foreign investors to buy government bonds, providing inflows of dollars into the economy.

Two other sources of dollar income are international tourism, which has continued to rise, and foreign currency remittances, or the money that people send, or bring in, from abroad. Remittances in 2018 had already exceeded $30 billion by the end of November. Income from international travelers, including border-crossers and cruise passengers, was up 6% at $20 billion. (Figures also up to November 2018.)

The peso has got off to a good start in 2019, with the wholesale exchange rate recently down to around $19 pesos to the dollar. The estimate in the Bank of Mexico’s latest survey of economists is that the exchange rate will end the year at 20.60 pesos to the dollar.

As we’ve mentioned before, these forecasts reflect what could be expected given estimates for inflation, economic growth, interest rates and other economic variables, both in Mexico and the U.S., but they don’t take into account extraordinary events as these are basically unknowns.

The weaker peso has its advantages and disadvantages.

To begin with, it makes Mexico’s exports relatively cheaper, and therefore more competitive in the international market; although a currency heading too low can cause unhelpful inflationary pressures domestically.

The lower peso makes vacationing in Mexico a more attractive option, and retirees living here with dollar-denominated pensions will find that their incomes stretch further when purchasing locally-produced goods.

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, and locally-grown food, 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 in more recent times, and today a higher dollar will only add to the cost of things such as imported goods, and products that require imported components.

Currency exchange rate predictions are often based on what economists call “fundamentals”—which include things like 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.—but global economic and political events in particular have a tendency to sideswipe economists’ logic: three years ago, experts and surveys predicted the Mexican peso would recover from its then-lows of 15; in the event it has moved to trade lower.

What most people want to know is what the exchange rate will do next, and here the Spanish expression “no tiene palabra,” or “it can’t be trusted,” is relevant. The safest answer to this question is to say that most year-out forecasts are usually wrong—probably more a matter of random error than ineptitude: a banker once described currency forecasting as “a mug’s game.”

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