Portfolio investment inflows welcomed in Mexico

The interest rate premium (between peso and dollar investments) creates an attractive “carry trade” opportunity, especially when coupled with a stable or appreciating exchange rate. Investors who can borrow in dollars or other currencies where interest rates are low can invest in higher yielding peso instruments, reaping the interest rate differential and generating handsome profits. Obviously, if the peso devalues, profits can disappear. The Fed's QE2 (the second round of quantitative easing) adds fuel to the carry trade fire.

Mexico is only one of many countries in which investors are playing the carry trade game. The peso has appreciated less than the exchange rates of some other “emerging countries”, whose governments are quite concerned about the impact of a strengthening currency on trade flows and the creation of stock and property bubbles.

Governments ranging from Chile and Brazil to Thailand and Malaysia have imposed measures ranging from taxes to limits on investments in short-term money market instruments to try to dampen the negative effects of an appreciating exchange rate based on portfolio investment flows. Mexico has not.

Mexico’s policy was summed up by Banxico Deputy Governor Manuel Sanchez in a November 18, 2010 speech delivered at a Cato Institute symposium: “…capital controls may lessen investor confidence in these economies [countries that impose capital inflows], generate black markets, and inhibit the entry of capital necessary for innovation and productivity improvements. Currency interventions, in turn, are hardly effective and tend to impose financial losses on the central bank. Furthermore, the most important threat generated by these actions is a widespread movement toward protectionism that could hamper the sustained recovery of the world economy. Thus, it is preferable to completely avoid these measures.”