Mexican Peso Dragged Lower by Rating Jitters

The short-term speculative market likes the Mexican peso. The net long speculative position at the IMM has risen sharply in recent weeks. The net long non-commercial position rose to 70.8k as of last Tuesday up more than 6-fold since late July. A number of investment houses have recommended long peso positions as a way to take advantage of the global upturn and in particular the revival of the auto sector in the US.

We have been less sanguine and have been concerned about inability of President Calderon to enact his program without a majority in Congress. We have been concerned about the violence in Mexico and the fact that the state does not have a monopoly on the use of force. We have also been concerned about how Mexico competes in the world economy when it cannot rely as it has in the past on providing cheap labor and the "domestic content" bridge for both the EU and US.

To be sure these may appear to be longer term issues but they also have more immediate implications. Today and S&P analyst warned that Mexico's rating could be cut before the end of the year if the government fails to broaden the tax base to offset the declining oil revenues.

S&P currently give Mexico a BBB+ rating. Our own proprietary rating surprise model warns that Mexico's fundamentals would justify a BBB- rating, the lowest of investment grades.

What seemed to prompt S&P comments is the fact that next week Mexico will turn its attention to next year's budget. The PRI regained its prominence as the largest party in the lower house in the elections in early July. The PRI seems determined to block serious reforms, apparently hoping to recapture the presidency in 2012. The government is to send a draft budget proposal to Congress (inaugurated tomorrow) by Sept 8. The PRI is pushing the government to cut spending rather than increase taxes. Yet since May, the government has announced spending cuts totaling MXN85 bln or ~$6.4 bln.

Ultimately, S&P is right. Mexico has one of the lowest rates of tax collection in Latin America. The total tax collected (local and federal) was about 19% last year, almost half the median of other countries rated BBB+. For its part, Moody's analyst assumes the government will contain the deficit not by serious tax reform but by raising duties on goods that are controlled by the state, like tobacco, alcohol, fuel and electricity, which do not appear to be long-term solutions. On Aug 7th , Moody's reaffirmed its rating for Mexico at Baa1, which is equivalent to S&P BBB+, and a stable outlook.

Over the past 5-6 sessions, the dollar has appreciated almost 5% against the Mexican peso. We suspect there may be further dollar short-covering (long peso liquidation. The immediate target is around MXN13.43 and then MXN13.60. But rather than chase the dollar now, look for a pullback in the MXN13.20-MXN13.25 as a better risk-reward opportunity to buy US dollars or hedge MXN exposure.