VOLATILITY IN MEXICAN FINANCIAL MARKETS

UNCLAS SECTION 01 OF 02 MEXICO 003136

SIPDIS

SENSITIVE
SIPDIS

FOR WHA/MEX AND EB/IFD/OMA
USDOC FOR 4320/ITA/MAC/WH/ONAFTA/ARUDMAN
TREASURY FOR IA - DAVID BECKWORTH

E.O. 12958: N/A
TAGS: ECON EFIN MX
SUBJECT: VOLATILITY IN MEXICAN FINANCIAL MARKETS


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1. (SBU) Summary: During the week of May 29 econoffs and FSN
ECON specialist talked with a broad range of analysts and
economists from foreign banks and the Mexican Stock Market.
Their reading was that the recent volatility in Mexican
financial markets was directly tied to capital flight from
emerging markets to safer markets paying higher interest
rates. But, as presidential elections draw near, the
political factor has begun to play a role. Political
uncertainty and fear of a victory of the Democratic
Revolutionary Party's candidate, Andres Manuel Lopez Obrador
(AMLO),have led a few sophisticated investors to begin
taking precautions, shortening long-term positions and moving
assets out of the country. Nonetheless, most sources report
that Mexican economic fundamentals including a flexible
exchange rate, large inflows of crude oil revenues and
remittances, low interest rates, solid public finances,
strong financial institutions, and prepaid foreign debt
remain robust. End Summary.

HIGHER INFLATIONARY EXPECTATIONS AND INTEREST RATES
-------------- --------------


2. (SBU) During the past couple of months, jitteriness has
been seen in emerging financial markets, including Mexico.
Inflationary risks and the fear of higher interest rates in
the U.S., Europe and Japan leading to a global economic
slowdown have shaken stock markets and foreign currencies
worldwide. During the past three years, with excessive
liquidity worldwide, investors poured money into emerging
markets to capture higher interest rates. But, after hikes
in commodities prices and expectations of a tighter monetary
policy by the Federal Reserve, fund managers began shifting
money out of high-risk markets to more secure investments,
like U.S. Treasury bonds.


3. (SBU) All the analysts we polled indicated that the recent
capital flight seen in Mexico was the result of the reduced
spread between Mexican and U.S interest rates, currently at
200 bps. As Mexico's country-risk has increased from a
record low of 94 bps in March to 145 bps the last week of
May, local funds' strategy during the past month has been to
shorten long-term positions (10-year M Bonds). Local
investors are lowering their risk profile because of the
fewer portfolio diversification options they have compared to
foreign investors. From April to the last week of May,
approximately MP 9.4 billion (USD 840 million) in Mexican
government bonds held by foreign investors left the country.
For years, foreign investors have stayed in the long end of
the curve, but they could decide to close these long-term
positions if their perception of Mexico's political
environment worsens. An optimistic Edgar Camargo, chief
economist of Bank of America in Mexico, told us that he
doesn't expect further foreign capital flight, at least not
more than USD 500 million.

STOCK MARKET FALLS 10.5% IN MAY
--------------


4. (SBU) The IPC, the Mexican Stock Market's main index, fell
10.5% in May. After hitting a record of 21,822 on May 9, the
IPC dropped to 18,677 at the end of the month. Alejandro
Reynoso, Deputy Director and Chief Economist of the Mexican
Stock Market, and the most pessimistic of the economists with
whom we spoke, explained that this volatility was the result
of external and domestic factors. He agreed that capital was
leaving Mexico principally as a result of expected higher
interest abroad. Domestically, he added that changes in
regulations effective in 2005, had lifted restrictions on
pension fund investment in foreign assets. To date, Siefores
(Specialized Retirement Investment Societies) have invested
between USD 3 and 3.5 billion in foreign securities. He
noted that this was equivalent to inward foreign direct
investment over the same period.

SOPHISTICATED INVESTORS CONSIDER PRECAUTIONS
--------------


5. (SBU) Reynoso added the uncertainty about the upcoming
elections, the tie between frontrunners National Action Party
candidate Felipe Calderon and Revolutionary Democratic Party
candidate AMLO, miners and teachers unions' conflicts
throughout Mexico, and a recent shooting at a car with Carlos

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Ahumada's family inside (Ahumada is a businessman
incarcerated after videos of him bribing PRD politicians were
made public),have not gone unnoticed by investors. As
evidence that a few sophisticated investors were growing
concerned by political developments, Reynoso described a
Siefore that had just pulled USD 80 million from the domestic
market to buy S&P 500 index securities in an expensive
transaction with an exchange rate as high as MP 11.36 to the
dollar. This Siefore expected the exchange rate to climb up
to MP 12.00. In a second case, one hedge fund manager called
Reynoso after the June 6 morning shooting telling him that
the fund would shorten its positions in Mexican securities.
Reynoso is also seeing in increase in transfers of locally
acquired foreign securities to U.S. banks from their branches
in Mexico. More than a fraudulent scam, since these
transfers are not reported to tax or money laundering
authorities, Reynoso sees it as a precaution against the
possibility of less market-friendly policies should AMLO win
the election. Reynoso personally believed the chance of
unrest arising from the election leading to a precipitous
fall in Mexican markets was low, but the magnitude of such a
politically driven fall would be significant enough that the
most sophisticated domestic and foreign investors were taking
limited defensive measures.

MARKETS' REACTION TO DIFFERENT POLITICAL SCENARIOS
-------------- --------------


6. (SBU) All analysts agreed the most positive scenario for
financial markets is a victory of the rightist candidate
Felipe Calderon by a large margin. Markets would rise and
investors would be more relaxed. The worst scenario would be
if AMLO wins but fails to announce his economic team quickly
(Note: Reynoso mentioned Javier Beristain, former finance
secretary during PRD Cuauhtemoc Cardenas' tenure as Mexico

SIPDIS
City Mayor as a good candidate to become Secretary of
Hacienda). If the Federal Electoral Institute is unable to
announce a winner the week of July 3, pressure on local
financial markets will also increase. If Calderon wins by a
tight margin, AMLO could take his supporters out on the
street alleging fraudulent elections. Still, analysts don't
expect these demonstrations to last. Reynoso felt the IPC
could fall 15% and the peso could depreciate as much as 10%
if AMLO continues to promote an environment of uncertainty
over what his economic intentions would be as President.


7. (SBU) Comment: In a scenario of a shrinking money supply,
risk aversion to emerging markets, and worldwide portfolio
adjustments, Mexico needs a solid and stable economic policy
to successfully compete against other emerging markets in
attracting investments. The uncertainty of the electoral
process' outcome remains a latent risk for the stability of
local financial markets. There is some anecdotal evidence
that local and foreign investors have reduced their Mexican
exposure and there is a chance for more rebalancing if the
political environment deteriorates before and after July 2.
Despite the difficult and uncertain electoral process, the
majority of analysts and government authorities are confident
in Mexico's sound economic variables: a flexible exchange
rate, large inflows of crude oil revenues and remittances,
low interest rates, solid public finances, strong financial
institutions, and prepaid foreign debt, which will absorb any
volatility shocks. End comment.


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