Exposed to the winds of fortune
Since the start of the year, investor concerns have led the Brazilian real and Mexican peso to underperform. Overall, investors have a nuanced view of the challenges facing these two countries and their currencies. The Brazilian real’s problems look far more serious over the medium term than those facing the peso. Thus, while the peso had recouped most of its pandemic-induced losses against the greenback by the start of this year, the real’s rebound has been far more miserly. This suggests that the fiscal outlook has become the principal factor driving the Brazilian currency.
The government’s ongoing commitment to a constitutional spending cap (which fixes a ceiling on state spending in real terms) is therefore key to the outlook for the real. Yet with mandatory expenditures representing over 90% of public spending, there is very little room for flexibility in spending. At the same time, the real’s cheapness may provide some support. Having already started to intervene in currency markets to prop up the real, the Brazilian central rose raised the Selic rate by 75 bps to 2.75% on 17 March. The central bank may pursue the ‘partial normalisation process’ at its next policy meeting on 5 May.
Unlike many other countries, Mexico refrained from issuing new debt during the pandemic to support the economy. Alongside limited fiscal expansion, Mexico’s central bank (Banxico) has been accommodative, despite relatively high inflation. Banxico cut its policy rate (the target for the overnight interbank interest rate) by 25bps to 4.00% on 12 February even though inflation was above its 3% target.
Overall, Mexico faces fewer public debt challenges than Brazil in the coming months. However, economic growth, usually a key driver for EM currencies, may remain underwhelming because of the limited fiscal expansion. Furthermore, there is an increasing risk that real policy rates in Mexico move into negative territory, as inflation is likely to rise further in the short term and Banxico does not seem ready to call an end to easing.
Over the medium term, we prefer the peso to the real as idiosyncratic risks in Mexico are significantly lower than in Brazil. However, the peso’s upside potential could be limited by the flaccid growth outlook for the Mexican economy. Brazil faces a narrow path to debt sustainability, with little room for policy mistakes—but a revival of the reform agenda in Brazil and a more hawkish BCB could provide some short-term support to the real in the coming months.
All things considered, while we are leaving our forecasts unchanged for the USD/MXN rate (our three-month forecast is MXN21.00, our six-month forecast is MXN20.40 and our 12-month forecast MXN19.80), we have decided to tweak higher our short-term forecast for the real. Our new three-month projection for that currency stands at BRL5.30, while our six-month and 12-month forecasts are left unchanged at BRL5.50 and BRL5.80 respectively.