Mexican peso banknotes are pictured in Ciudad Juarez, Mexico.

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Remittances and tight monetary policy have helped keep the Mexican peso strong


Photo Credit: REUTERS/Jose Luis Gonzalez

Author's note: I thank Olivier Blanchard, Martina Copelman, Monica de Bolle, Cullen Hendrix, Alexis Milo, Maury Obstfeld, Angel Ubide, and other PIIE colleagues for their comments and suggestions.


The election of Claudia Sheinbaum as the first female president of Mexico on June 2 was widely hailed as historic, but markets were not so impressed. Following her victory to succeed her mentor, President Andrés Manuel López Obrador, the Mexican currency got battered, experiencing one of its largest weekly depreciation in years.

Yet that depreciation masks a larger trend: The Mexican peso is the emerging-market currency that has strengthened the most since the COVID-19 pandemic, generating a debate among economists about its sustainability. Since its weakest level during the pandemic, the Mexican peso has appreciated by approximately 30 percent in nominal terms. The peso's appreciation was cited as "scary" by Robin Brooks, then managing director and chief economist of the Institute of International Finance: "The Peso has risen so much in real effective terms that it's causing a big deterioration in Mexico's underlying current account balance," he said. "Add to that what might happen if Trump wins in November, and I think the Peso is very vulnerable…."

Figure 1 presents several measures of the real value of the peso: three multilateral measures (from the Bank of Mexico [Banxico], the International Monetary Fund [IMF], and the Bank for International Settlements) and the bilateral exchange rate vis-à-vis the US dollar. One of the three multilateral real exchange rate (RER) measures, Banxico, has reached levels of overvaluation similar to those registered before the tequila crisis of 1994. However, the other two multilateral RERs and the bilateral exchange rate are still at levels similar to the means of the last three decades.

The large appreciation of the peso has brought these measures of the real exchange rate back to their 2015 levels, before Donald Trump launched his campaign for the presidency with a strong anti-Mexico message focused on trade protection, a border wall to stop illegal immigration, and measures to tax remittances—policy proposals that triggered a large depreciation of the Mexican currency. Another important sign that points towards the absence of an external disequilibrium is a current account deficit that in the last three years has hovered around 1 percent of GDP, below the 1.6 percent of GDP "norm" considered sustainable by the IMF for Mexico.

Why then, do models of the underlying current account and the equilibrium real exchange rate point towards overvaluation? This is explained to a significant extent by the growth of remittances in the last eight years. Since 2016 remittances have increased by 3 percentage points of GDP, making income from abroad a more important determinant of external sustainability. It seems these models are not capturing this structural change in the process driving remittances well. If we subtract remittances from the current account deficit (figures 2 and 3), this measure shows as having reached levels in the last two years that point towards external vulnerabilities, assuming the recent changes turn out to be transitory. Monetary authorities should consider whether accelerating the pace of reserve accumulation (to substitute for the IMF's flexible credit line) might be a prudent policy given the strong position of the current account.

The strength of the peso does not only reflect this increase in remittances. The peso also responds to the very large monetary policy interest rate spread vis-à-vis the federal funds rate, the large amount of international reserves held by the Bank of Mexico, a historically low level of country risk, and the expectations that nearshoring of manufacturing capacity from Asia will have a strong effect on Mexico's exports. Therefore, the combination of a strong current account balance, large interest rate differentials, and a healthy central bank balance suggests the strong peso is the consequence of the structural strength of remittances and a very tight monetary policy. But the current level of the currency is not inducing an external disequilibrium situation that warrants a strong correction. On the monetary policy side, the real policy interest rate and the interest rate differential versus the federal funds rate are at historically high levels.

From the real sector, one can see some signals that the combination of very high interest rates and a strong currency is holding back growth, as Mexico has recovered more slowly than other Latin American economies since the pandemic. Therefore, from an internal equilibrium perspective, employment and output in Mexico could benefit from a weaker currency.

As we move into the second half of the year, some of these factors are starting to change or to be questioned by capital market participants leading to a weakening of the peso.

First, there is uncertainty about the policies of the incoming president of Mexico regarding the sustainability of fiscal policy geared to maintaining a low debt-to-GDP ratio. There is also uncertainty over the expected weakening of the rule of law, the possibility of increasing the supply of renewable energy to face the increasing demand from a growing economy, and how fixing the most indebted oil company in the world, Pemex, will put pressure on the peso.

Second, the Bank of Mexico will rightly question the wisdom of maintaining such a large interest rate differential once inflation has declined and the economy slows down as it always does during the first year of a new government.

Third, as the US election gets into full swing, migration, fentanyl deaths in the United States, potential revisions of the US-Mexico-Canada Agreement, and the establishment of new tariffs will generate doubts about the future growth of remittances, exports, and US investment in Mexico.

All of these factors might contribute to a weakening of the Mexican peso.

Data Disclosure

This publication does not include a replication package.

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