At the start of January, when the Mexican Central Bank spent $2 billion to defend its currency in a rare intervention in the spot market, and which lasted just a few hours before the selling resumed, Goldman analyst Albert Ramos had some advice for Banxico: don’t use reserves to defend the Peso as Mexico would have greater need for them elsewhere.
Instead, Goldman’s advice was to engage in derivative transactions using swaps to intervene, something China did back in 2015, to wit: “In our assessment, if the MXN remains under pressure the authorities should entertain the possibility of using different intervention instruments, such as USD Dollar swaps, for they are not a direct claim on reserves and offer valuable FX hedging protection to the market in a period of significant uncertainty but no large spot market outflows.”
Less than two months later, the Mexican Central Bank took Goldman’s advice.
On Tuesday the Foreign Exchange Commission (FEC) announced today that Banxico was instructed to offer dollar FX hedge to the market for up of US$20 billion. The hedging instruments will settle in local currency and will have a maturity of up to 12-months. The first auction of up to US$1bn will take place on Monday, March 6. The central bank will renew all maturing hedges while the FEC considers it “pertinent”.
The FEC stated that in recent months the MXN/USD has shown high volatility, which “is not consistent with the country’s economic fundamentals.” Given that, and with the objective of fostering a more orderly functioning of the FX market, the FEC instructed the central bank to implement an FX hedge program (settled in local currency, which will allow offering of hedging/insurance against foreign exchange risks, without using international reserves).
Finally, the FEC reiterated the commitment to monitor the FX market operating conditions and it does not rule out the possibility of additional actions if needed, through the use of the hedging instruments announced today or the instruments used in the past (read, FX spot market intervention). In all cases, the FEC reiterated that the anchoring of the MXN will continue to be sought mainly through the preservation of solid economic fundamentals; this suggests that the authorities are not keen on large and extended intervention programs.
The result was a sharp move higher in the peso, with the USDMXN tumbling from 20.40 to just over 20.00, a level not seen since the Trump presidential victory.
So, with Goldman’s clearly adopted, here is the same Alberto Ramos with his take on what the Mexican announcement means for the Peso and for currency markets.
In our assessment, this is a very welcome development. As we argued in the Jan 27, 2017 Latin America Economic Analyst “Mexico: Comfortable International Reserves Coverage but Limited Intervention Firepower,” given the limits on using reserves for intervention, the authorities should explore the use of alternative intervention instruments, such as Dollar swaps, given that they are not a direct claim on reserves as they settle in local currency, and offer valuable FX hedging/protection to the market in a period of significant uncertainty but no spot market outflows. That is, reserves should be kept aside for whenever there is evidence of sizeable spot market capital outflows.
Swap and forward transactions—which according to a recent IMF paper have been used by around one-third of EM countries—have been playing an increasing role in reserve management and in providing the private sector with a mechanism to hedge exposure without having to actually divest and disengage from a market. One of the advantages of forward and swap arrangements (through non-deliverable futures) is that the authorities are able to manage domestic liquidity and intervene in the spot market without impacting headline official reserve figures. In fact, according to a recent IMF paper studying FX market intervention in Brazil, in the case of negligible convertibility risk “the impact of spot market intervention … is strikingly similar to that achieved through futures based intervention worth an equivalent amount in notional principal.”
The US$20bn supply of Dollar hedge is a reasonable initial amount to test the effectiveness of the new instrument and assess not only the overall demand for FX protection, but also the origins/composition of such demand. However, the authorities should stand ready to increase the amount beyond the US$20bn announced today in case of added shocks to the MXM. After all, Mexico is a highly financially integrated economy with a very open capital account. A significant amount of foreign money is invested in local markets: currently about US$105bn in local fixed-income and US$128bn in local equities. Furthermore, the accumulated stock of FDI in Mexico is now estimated at approximately US$500bn.