MEXICAN FINANCIAL UPHEAVAL : Q & A : What the Free Floating of the Peso Could Mean for Investors, Others

What are the immediate and long-term repercussions on workers, investors and business people on both sides of the border from Mexico’s decision Thursday to let the peso trade freely against the dollar? Here are some answers:

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Q: What happened?

A: The Mexican government, which has been holding the value of its currency fairly steady for seven years, moved to let it float against the dollar--making its value subject to market forces just like the values of the German mark, British pound, Japanese yen and other major world currencies. But because the Mexican government has been keeping its currency’s value artificially high, Thursday’s surprising move resulted in the peso plunging--more than 20% on Thursday and more than 30% since last Friday.

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Q: Why is this important?

A: The peso’s stability has been at the center of Mexican economic reforms, which have stabilized wages and consumer prices and attracted huge sums in foreign investment. By pulling the rug out from under the peso, many investors believe, the government is signaling a change of heart. If Mexico returns to its past of high inflation and currency devaluation, that could have a disastrous impact on business, employment and investment in the country.

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Q: Then why did Mexico do this?

A: There are several factors, but a primary one is that the government was depleting its foreign reserves by trying to prop up the peso at levels still seen as overvalued by the world currency markets. The government spent an estimated $4 billion in foreign exchange reserves over the past two days alone to keep the currency from falling further. That had depleted those reserves to $6.5 billion--down from $17 billion as recently as Nov. 1.

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Q: How does this affect the average U.S. citizen?

A: The repercussions are potentially dramatic, though somewhat indirect. Mexico is one of California’s largest trading partners, buying everything from electronic components to chemicals to lumber, while selling such products as textiles, produce and leather.

If the peso remains weak, Mexicans will be forced to pay more for U.S. goods. That could hurt sales by exporters and manufacturers and ultimately lead to layoffs of U.S. workers.

However, Americans traveling to Mexico or buying Mexican products are likely to see their dollars go further than ever before.

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Q: How will this affect illegal immigration?

A: Many illegal immigrants come here because of economic woes in their own country, which could be exaggerated by the currency swings, says Max Schetter, director of the economic research bureau at the Greater San Diego Chamber of Commerce.

Further, U.S. dollars now buy more in Mexico. That creates a huge incentive to come here, earn dollars and send them to relatives south of the border. The currency devaluation “is like an electromagnet attracting Mexicans to the U.S. economy,” Schetter says.

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Q: Why would this create an economic burden on Mexican citizens? After all, if you’re earning pesos and buying products with pesos, why would you care about the value of the peso when compared to a foreign currency?

A: In a nutshell, a decline in the value of the peso creates inflationary pressures inside Mexico. That’s simply because Mexican companies are buying goods from international suppliers. The cost of those goods is now higher.

Additionally, Mexico’s domestic producers can raise their prices because they’re now competing with higher-priced foreign goods. Workers, grappling with a higher cost of living, may demand higher wages. If they get higher wages, inflation is boosted even more. If they don’t, they must live more sparsely--and their average standard of living is already far lower than that in the United States.

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Q: What does this mean to investors in the Mexican stock market?

A: It’s still too early to say for sure. In theory, the devaluation should boost exports of Mexican goods and services. That would be good for the economy and business as a whole.

But because the value of the peso dropped so dramatically, some experts believe any boost to exports could be more than offset by inflationary pressures within Mexico. Moreover, they worry that the confidence of foreign investors was shattered by this move, largely because the government of President Ernesto Zedillo had assured investors Wednesday that it would not allow its currency to fall further.

With Thursday’s action, investors rightly questioned whether the Mexican government is serious about keeping its promises to investors, says Alan Shapiro, chairman of the finance and business economics department at USC.

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Q: What about Mexican bonds?

A: Again, there are some uncertainties, but the prognosis appears bleak. Short-term interest rates have already been boosted, which hurts bond values. U.S. investors, who bought peso-denominated bonds, get doubly hit with the huge drop in the value of Mexican currency.

Even dollar-denominated bonds issued by Mexican companies are at risk, says Carl Ericson, vice president and manager of the Colonial Investments Strategic Income Fund. That’s because these companies are still earning the bulk of their income in pesos, but they’re paying on their debt in costly foreign currency. That puts strain on their balance sheets and makes them comparatively less credit-worthy, he says.

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Q: Should I sell my funds that hold Mexican securities?

A: At least nine U.S. mutual funds investing in Mexico lost more than 8% of their value in the past two days. While it’s rarely smart to sell in a panic, it certainly makes sense to evaluate why you’re investing in Mexico and whether the reasons you first invested still hold true. You should also monitor the economic climate there to make sure your investments won’t suffer in an inflationary environment.

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Q: I’m about to go on vacation in Mexico. Does this mean my hotel and everything else is going to cost less?

A: Possibly but not necessarily, says Paul Albrecht, director of industry relations at Globus-Cosmos Tourama, a travel wholesaler that arranges land tours all over the world. Many tourist hotels set their rates in U.S. dollars. If that’s the case, they’re unlikely to give you a break.

However, your meals and souvenirs are likely to be significantly cheaper. Additionally, people who stray from traditional tourist areas and buy products and services in pesos will see a surge in spending power, he says.

“This is terrible for people who invest in Mexico but great for people who travel there,” Albrecht says.

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