Photo: posta.com.mx

By THÉRÈSE MARGOLIS    

Every time the Big Three international rating agencies downgrade the country or it’s state-run oil venture, Petróleos Mexicanos (Pemex), Mexican President Andrés Manuel López Obrador (AMLO) proudly points to the fact that the peso is doing well against the U.S. dollar, with a parity now below 19 to 1.

And in most financial universes, a strong currency is a sign of a solid economy.

But in order to understand why, in this case, a strong peso is not necessarily a good thing, you have to consider that, for the most part, it is the result of a concept called carry trading.

Essentially, carry trading is a process by which investors borrow money from a nation where interest rates are low, and then invest in short-term bonds or other financial documents (in this case, Mexican Federal Treasury Certificates, known by their acronym CETES) that have high interest rate payoffs.

If, for example, an international investor gets a loan in U.S. dollars (which accounts for about half of all financial transactions worldwide, and the lion’s share of the carry trading revenue sources in Mexico) at a rate of 3 to 4 percent (the U.S. Fed rate is currently at 2.5 percent) and immediately reinvests that money in a 28-day CETES at 20 percent, he or she can make a hefty profit just by waiting around for a month to earn the Mexican interest before repaying the dollar loan at a minimum interest rate.

Now, that is all very well and good for both the carry-trade investors and, in this case, for the Mexican government, which benefits from a constant flow of liquidity in the form of CETES purchases, liquidity that allows for AMLO to pay for social and other programs.

But – and here’s the catch – investors are only willing to play the admittedly high-risk carry-trade game as long as they have confidence in the economy of the country where they are buying the bonds.

So, while the Mexican peso may look good for carry traders at the moment, it begins to lose some of its sparkle as the Mexican economy begins to contract and uncertainty sets in as a result of constantly dimming forecasts for the future.

Like any high-risk investment program, carry trading in a here-today-gone-tomorrow get-rich-quick scheme that can blow up at any time.

Also, unlike long-term investments, such as in the case of manufacturing plants, the traders can pull their cash out with no advance warning, and leave the country high and dry with its unsold CETES.

Moreover, carry trading does not produce jobs (something Mexico desperately needs)      nor tangible goods that can later be  sold.

And the Central Bank is eventually forced to print more money to pay off the treasury certificates, which, in the end, leads to a devaluation of the currency.

There are other serious consequences of an overvalued peso.

To begin with, a high peso means products produced in Mexico become more expensive and less competitive in the global marketplace.

If a Mexican-made tire used to cost 1,000 pesos, which at a rate of 20 pesos to a dollar translated into $50, that same tire at a rate of 19 pesos to the dollar now costs nearly $53, which means it may not have the same international competitive edge that is did six months ago.

In other words, exports become too expense to compete and imports become cheap.

Cheap imports and expensive exports can quickly turn into a detrimental trade imbalance.

Besides being capricious, the carry trade has some other very negative connotations for the countries in which they are conducted.

In 2013, Morgan Stanley Chase coined a term for a handful of emerging markets that were too dependent on unreliable foreign investments to finance their growth ambitions: the “Fragile Five.”

These countries, Morgan Stanley argued, seemed to be showing economic growth, but had precarious current account balances, low reserves to external debt ratio, foreign holdings of government bonds, U.S. dollar debts, inflation and real-rate differentials, all factors that threaten Mexico’s economy.

At the time, the Fragile Five included Brazil, India, Indonesia, South Africa and Turkey, and all of them later suffered severe economic setbacks as a result of being carry-trade investment recipients.

In the end, when the carry traders moved on to greener pastures, all of their economies took a severe hit, and so did their currencies.

Today, according to the World Economic Forum (WEF), there are a new Fragile Five, which include Venezuela, Brazil, Pakistan, Egypt and, yes, Mexico.

Carry trading – particularly in Mexico, where almost all trades originate from U.S. dollars – is only profitable as long as the U.S. Federal Reserve keeps interest rates low (they are up for review again at the end of July).

Most analysts predict that the rate will go unchanged or even drop lower, but sooner or later, the Fed will raise interest rates, and the strong-peso CETES castle that AMLO has been counting on to finance his economy may then come tumbling down.

In short, the peso’s stability depends heavily on the U.S. economy.

If the U.S. dollars strengthens, if the Fed raises interest rates, Mexico’s carry trade market will dry up, and the government will be hard pressed to find serious, long-term investors to compensate for the lost revenues.