The Mexican peso (MXN) ranks as the ninth most traded currency in the world and the third in the Western Hemisphere behind the US dollar (USD) and Canadian dollar (CAD). MXN crosses with USD attract fewer participants than major pairs including the euro (EUR/USD) and yen (USD/JPY), but the currency still offers highly liquid access to Latin America and emerging market growth opportunities.
MXN has transformed from a developing world currency into a formidable international financial instrument in recent decades. (See also: Emerging Markets: Analyzing Mexico's GDP.) While forex trading has also boomed worldwide during this period, three specific catalysts have driven the currency’s rapid growth.
1. Crude Oil
As the 12th largest oil producer in the world, Mexico ties its currency to energy prices because its vast reserves provide collateral for borrowing. The money from borrowing allows the Mexican government to invest in domestic spending programs. International lenders are more willing to invest and assume risk in petroleum-dominated countries when crude oil prices are high. When the price of crude oil hit an all-time high in the middle of the last decade, this generated an economic boom throughout Latin America.
Oil production accounted for close to 6% of the country’s export revenue in 2017, and currency swings intensify when crude oil is moving sharply higher or lower. In addition, the government levies high taxes on Pemex, the state-owned oil giant, which accounts for 10% of all taxes collected in the country in 2016 and 2017. This significantly adds to MXN’s dependence on energy prices.
As a non-member oil producer, Mexico has been hard hit by an OPEC supply buildup, adding to the pressure created by a multiyear decline in oil production. While new reserves suggest, the tide may turn and support an increase in output that will underpin the value of its currency, challenges from the flight of emerging markets could cancel out those gains. (See also: Is Mexico an emerging market economy?)
2. Proximity With the United States
Mexico and the United States share a border and a relationship that extends into broad trade agreements and chronic political discord aggravated by immigration and drug trafficking. Physical proximity has an additional effect on the peso’s value, with highly populated border regions engaging in commercial interactions that add significantly to MXN liquidity while forcing continuous resets on the relative value of the currency compared to the U.S. dollar.
The USD/MXN forex pair offers a natural currency play and is also the most liquid MXN pair. With regard to trade, the United States exported $243 billion in goods to Mexico in 2014 while importing $314 billion, adding significant liquidity. This Balance of Trade (BOT) showed significant fluctuation in the last decade with the shifting ratio having an impact on relative value. MXN has been on the losing end of this equation, falling relative to the dollar for more than 20 years.
3. Central Banks and the Hunt for High Yield
Central Bank stimulus after the 2008 economic collapse, starting with the first round of quantitative easing (QE) in the U.S. in March 2009, lowered yields on bond instruments in from developed countries including the United States and the eurozone. Hot money funds responded by turning their attention to emerging markets and developing countries where higher yields equated to higher profits. This is commonly known as the carry trade.
This imbalance triggered a multiyear surge of capital into emerging markets, including Mexico and Latin America. At the same time, China's industrial growth exploded increasing demand for commodities that added further enhanced the liquidity of currencies in emerging markets, including MXN. These forces combined to trigger a historic growth spurt south of the U.S. border.
Challenges in the Coming Years
Falling crude oil and commodity prices have undermined Mexico’s growth while oil production continues to decline to escalate the downside effect. This has contributed to a historic collapse in the peso compared to the U.S. dollar and euro. This collapse has dampened MXN liquidity at the same time that capital flows have reversed with hot money exiting Latin American economies.
Meanwhile, U.S. quantitative easing has come to an end with bond yields coming off multi-decade lows encouraging capital to return to local venues. Continued strengthening in the U.S. dollar is adding to the exodus, which has the power to suck liquidity out of the peso in future years. Mexico has attempted to stem the tide by selling U.S. dollars, but the policy is having a limited impact.
Mexico’s corporations have added to the liquidity challenges because they have borrowed heavily in U.S. dollars, which are cheaper than local currency. This has raised debt levels significantly in recent years with servicing costs rising due to the peso’s decline. This removes tranches of capital that could have been allocated to products and services, in turn, underpinning the currency’s liquidity.
In addition, the Trump presidency is having a detrimental effect on the peso, which, as of March 2017, had fallen by 12% since the U.S. election of 2016. Trump's rhetoric on trade and immigration, which directly affects Mexico, is causing the currency to trade idiosyncratically.
The Bottom Line
The Mexican peso shows high liquidity for three reasons. First, it has vast crude oil reserves that contribute to international trade. Second, the country's physical proximity to the United States encourages billions of dollars in commercial activity. Third, it attracts international capital due to higher yields than those found in developed nations.