Tuesday, October 21, 2008

Capitalist Games Cause Peso Crash

Mexican companies' scramble for dollars caused the peso to fall 50% against the dollar

The Mexican peso hit a 10-year low against the dollar two weeks ago, falling almost 50% to 15 pesos to the dollar. The crash was precipitated by Mexican companies' scramble for dollars to cover their losses as the dollar unexpectedly increased in value two weeks ago.

The companies' losses have two principal causes: the companies' dollar-denominated debt and their positions in foreign exchange rate derivatives.

Holding debt in a foreign currency is a gamble. The numerical value of the foreign currency-denominated debt stays constant despite fluctuations in the value of the local currency against the foreign currency in question. For example, if a Mexican company takes out a USD$1 million loan when the dollar is worth 10 pesos, the debt is worth 10 million pesos at the time of the loan. However, if the peso suddenly falls to 13 pesos to the dollar while the company still owes USD$1 million, that million-dollar debt is now worth 13 million pesos, meaning the company instantly owes 3 million pesos more than it did before.

However, the gamble of holding foreign currency-denominated debt is nothing compared to the risks associated with the purchase of foreign exchange rate derivatives, one of the numerous forms of capitalist gambling on the global economy. Derivatives are calculated using a complex formula that is based on the value of underlying financial instruments--in this case, the exchange rate between the dollar and the peso. With foreign exchange rate derivatives, investors can literally bet on the value of the financial instrument.

In Mexico's case, investors bet wrong. When the dollar unexpectedly rose two weeks ago, Mexican companies posted enormous losses. Comercial Mexicana, Mexico's third-largest retailer, declared bankruptcy after racking up a USD$2 billion debt, $1 billion of which is due to bad "positions" (bets) in foreign exchange rate derivatives.

Comercial Mexicana isn't the only Mexican company that lost out in the deriviatives game. The Financial Times reports that Gruma, the massive corn conglomerate that produces Maseca corn flour for tortillas, posted USD$684 million in derivative losses on October 8. Cemex, North America's largest cement producer, lost over $700 million on derivatives.

The combination of derivatives losses and increased debt due to the unexpected increase in the dollar's value set off Mexican companies' scramble for dollars to cover their debts. The sudden Mexican speculation on the dollar caused the peso to plummet. Currency values are determined through supply and demand. Because Mexican companies were using pesos to purchase dollars, the demand for pesos dropped while the concurrent demand for dollars increased.

In order to stop the crash, Mexico's central bank spent about 11% of its international reserves in less than three days. The peso is slowly recovering, standing at about 13 pesos to the dollar today.

Last week the Mexican treasury department announced a probe into several Mexican companies who had recklessly purchased foreign exchange derivatives. Yesterday the National Bank and Values Commission (CNBV) told the Financial Times that it was expanding its probe to include the banks who sold the derivatives to the companies. The probe, however, is limited to determining whether or not the companies complied with Mexican law, which requires companies and individuals to report derivatives purchases.

The head of CNBV, Guillermo Babatz, lays the blame on the financial institutions who sold derivatives to the companies. “We would be shutting our eyes if we didn’t think that the people who were selling these instruments should have known better,” he told the Financial Times.

However, derivatives are notoriously complicated. Banks are often criticized for selling clients derivatives without adequately explaining the risks involved. But Dean Baker of the Center for Economic Policy Research in Washington, DC, stated in a recent Guardian article that banks often don't thoroughly understand the derivatives that they themselves create, which he argues was a contributing factor in the US economic crisis.

Despite the derivative-caused peso disaster, Babatz told the Financial Times that the CNBV does not want to consider greater regulation of currency speculation to protect, or at the very least insulate, the peso. “When you start restricting these sorts of things, usually you just end up throwing up inadequate restrictions. You should only resort to regulation when there is no alternative.”

Even if Mexico wanted to regulate derivatives and other forms of currency speculation, it's not clear that it could. Currency controls are strongly frowned upon by international financial institutions such as the International Monetary Fund and the World Bank, who play an important role in the Mexican economy. Furthermore, the North American Free Trade Agreement (NAFTA) only allows short-term currency controls during a financial crisis. This means that governments are only allowed to implement temporary controls after a crisis has already occurred, and they're not allowed to use currency controls to prevent a crisis.

The Mexican government claims that the peso crash will have no impact on poverty in Mexico. It says that it has taken appropriate measures to counter rising food costs by investing more money in social welfare programs. However, the crisis' impact on the poor in Mexico remains to be seen: Mexico's social welfare programs are notoriously insufficient.
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