20170111-法国巴黎银行-Mexico__Optimal_level_of_reserves_as_self-insurance_against_sudden_stops__maybe_insufficient_11页_401kb

Summary of the Document: Mexico - Optimal Level of Reserves as Self-Insurance Against Sudden Stops

Core Content

This document is a research piece by BNP Paribas analysts, focusing on the optimal level of international reserves in Mexico as a form of self-insurance against sudden stops and substantial outflows. The analysis is based on a microeconomic framework and aims to understand the implications for monetary policy and foreign investment in the context of evolving economic conditions and potential shifts in U.S. trade and immigration policies.

Main Viewpoints

• Sudden Stops and FX Risk: The risk of sudden stops and weighty outflows is increasing due to the high level of foreign participation in Mexico’s public debt and the currency depreciation of the Mexican peso (MXN) against the U.S. dollar (USD).
• Reserve Adequacy: The current level of international reserves in Mexico is close to the optimal level calculated using a self-insurance model, but may still be insufficient to fully counteract potential crises.
• Stress Test vs. Self-Insurance Model: The self-insurance approach yields a higher theoretical optimal reserve level compared to the IMF stress test method, suggesting that the current reserves might not be enough in a crisis scenario.
• Probability of Crisis: Based on historical data and current economic indicators, the probability of a sudden stop/weighty outflow is estimated at 40%.
• Optimal Reserve Level: The average optimal level of reserves across all scenarios is approximately USD 175 billion.
• Monetary Authority’s Actions: Banxico has been selling USD reserves to manage the currency, resulting in a net decrease of USD 1.81 billion in reserves during the week of 2-6 January 2017. This has left reserves at USD 174.7 billion, which is very close to the optimal level, but still insufficient unless the IMF’s flexible credit line is used.
• Foreign Participation: Foreign participation in Mexican public debt has declined due to currency depreciation, but remains high at 35.6% (USD 101.3 billion), representing 57.4% of international reserves.
• Inflow Composition: Inflows into Mexico over the last decade have been mostly portfolio investments, with FDI being less volatile but still a significant component of the external account.
• Policy Implications: The analysis highlights the reticence of the authorities to intervene more aggressively in the FX market, possibly due to uncertainty about the impact of U.S. policy changes.

Key Information

Optimal Reserve Calculation

• The optimal reserve level is calculated using a microeconomic model that minimizes the expected cost of holding reserves, considering:

  • The cost of GDP contraction in a crisis.
  • The opportunity cost of holding reserves.
  • The probability of a crisis.

• The model is defined by the equation:
  $$
  \operatorname {Min} \mathrm {E} (\mathrm {C}) = \alpha \mathrm {C} _ {0} + (1 - \alpha) \mathrm {C} _ {1}
  $$
  Where:

  • $ \mathrm{C_0} $: Contraction in real output due to a crisis.
  • $ \mathrm{C_1} $: Cost of holding reserves (carry cost).
  • $ \alpha $: Probability of a crisis.

• The first-order condition for the model is:
  $$
  \frac {\partial \alpha}{\partial R} (C _ {0} - r R) + (1 - \alpha) r = 0
  $$

Crisis Probability Function

• The probability of a crisis is modeled using a logistic function:
  $$
  \alpha = \frac{e^{j}}{1 + e^{j}}
  $$
  Where $ j $ is a function of:

  • Short-term external debt in MXN.
  • Half of foreign participation in local debt.
  • International reserves over imports.

• The current crisis probability is estimated at 40%.

Reserve Scenarios and Opportunity Costs

• The optimal reserve level varies based on the GDP contraction scenarios and the opportunity cost of reserves:

  • For a -1% GDP contraction and 4.00% opportunity cost, the optimal level is USD 168.4 billion.
  • For a -5% GDP contraction and 4.00% opportunity cost, the optimal level is USD 182.6 billion.
  • For 6.00% opportunity cost, the optimal level is USD 172.6 billion for a -2% GDP contraction.
  • For 8.00% opportunity cost, the optimal level is USD 173.8 billion for a -3% GDP contraction.
  • For 10.00% opportunity cost, the optimal level is USD 174.5 billion for a -4% GDP contraction.

• The higher the opportunity cost, the lower the optimal reserve level.

Current Reserve Level

• As of 27 December 2016, Mexico’s international reserves stood at USD 174.7 billion.
• This level is very close to the optimal level, but not sufficient to fully self-insure against a sudden stop unless the IMF's flexible credit line is used.

Strategic Implications

• The authors recommend long Udibonos 2019 (inflation-linked bonds) as a high conviction trade for Q1 2017.
• They also suggest long MXN via cheap options (e.g., USDMXN put @ 20.10 strike for a premium of 1.96%) as a hedge against potential FX volatility.
• The economic cost structure of Mexico is abnormal in terms of REER (Real Effective Exchange Rate), indicating that either inflation or the FX rate will need to adjust.

Legal and Research Disclaimer

• The document is classified as non-objective research.
• It is not investment research and does not constitute a marketing communication under MiFID.
• The information is for professional clients and may be subject to conflicts of interest.
• BNP Paribas does not provide investment, financial, legal, or tax advice.
• Indicative prices are not actual transaction terms and may vary significantly.

Annex: Contacts

• The document includes contacts for Emerging Markets Strategy and FX & IR teams across various regions.
• These contacts are for professional clients and Eligible Counterparties.

Conclusion

• The current level of reserves in Mexico is insufficient to fully self-insure against a sudden stop or weighty outflow.
• The probability of a crisis is 40%, and the optimal level is around USD 175 billion.
• The central bank’s reluctance to intervene more aggressively is linked to uncertainty about U.S. policy changes.
• The analysis suggests that Mexico needs more ammunition to effectively manage FX risk in the current environment.