March 7, 2005 12:55 am

Beyond Borders: El Corto’s days are numbered

Time is running out for El Corto. What might sound like the nickname of a Mexican bandit is, in fact, the title for an esoteric financial instrument that the Bank of Mexico (Banxico) has used successfully to tame inflation during the past decade. But speculation is mounting that the bank is now ready to take the Mexican financial market to the next level and move to an official reference rate.

The corto is the name given to the amount by which the money market must be kept short each day (corto is Spanish for “short”). By increasing the amount by which the market is shorted, the bank tightens monetary policy.

The amount of the corto seems trivial. Even after 10 raises in the past 12 months, it still stands at less than $7m. Almost nobody besides money market professionals understands it. It lacks transparency. And it seems an oddly indirect tool for controlling monetary policy.

While it had its uses in the mid-1990s, when inflation was out of control and setting a reference rate was unrealistic, it is seen as anachronistic in the current stable financial system.

Guillermo Ortiz, Banxico’s governor, appears in no hurry to replace the corto. He told the Financial Times last year that he expected the corto to go during his current term, which does not end until 2009, but that there was no urgency.

During the bank’s tightening during the last year, conducted to try to squeeze out a brief spike in inflation, the market’s response to each rise in the corto was predictable. Overnight rates would go up by 20 basis points. Rises by the US Fed similarly prompted Mexican rates to rise by 25 basis points. But January’s corto hike was greeted by a rise of only 10 basis points in overnight rates. The banks, particularly Citigroup’s Banamex and BBVA Bancomer, by far the biggest operators in the market, were annoyed by the diminishing opportunities for the “carry trade” whereby they borrowed at low short-term rates and took advantage of the much higher rates at the long end of the yield curve, and so decided to test Banxico’s resolve.

The response was immediate. At the next day’s auction, Banxico imposed a floor reflecting a full rise of 20 basis points. Its power to do this had not been used since the turbulence caused by the 1998 Russian default crisis.

Within a week, the same thing happened again when the market failed to adjust entirely for the Fed tightening. The message to the banks was: if you do not do the decent thing and raise rates in response to the signal, Banxico will do it. But economists received another message: that the corto on its own was no longer enough to achieve the impact Banxico needed.

The corto has had its advantages for Banxico. Ambiguity can provide a little cover. Also, it requires repeated increases to keep interest rates rising. If the corto is left unchanged for a while, rates can drift down – allowing the bank to soften its stance a little without seeming to do so.

But there are two reasons why it might now suit the bank to move to the transparency of a reference rate. First, recent inflation numbers, including last week’s finding that prices rose only 0.17 per cent in the first two weeks of February – far below expectation – suggest that Banxico is approaching the end of the tightening cycle. On Friday, Banxico raised the corto again to 77m pesos, or just below $7m. The fact that it did this, after a good inflation number, will probably increase speculation that it is nearing the end of the tightening cycle. The reception for a new system will be much more positive if rates come down the first time it is used.

Second, Mexico started tightening earlier than the Fed. With only the corto in place, the risk is that continued Fed rate rises would push Mexican rates higher, even if Banxico wanted them to come down. A reference rate would deal with this problem.

For this reason, the consensus of analysts is that the end of Banxico’s tightening cycle – likely in the next few months – will be greeted by a shift to a reference rate. The biggest argument against this is Mexico’s political situation, which is growing noisier as the July 2006 presidential election approaches. Some suggest that a rarefied political environment is not the best backdrop for Banxico to make itself more transparent. For this reason, they suspect any movement to a reference rate will wait until the election is safely over.

That line may, however, be unduly cautious. Conditions in the credit market suggest monetary policy decisions, for all their profound effect on the economy, will continue to have little direct impact on the nation’s pocketbooks. That, in turn makes the bank’s decisions less politically salient.

Even though overnight rates rose by 450 basis points last year, credit exploded. For the first time in decades, commercial banks significantly increased the credit they extended to all the main sectors of the economy. Credit to the private sector grew 25 per cent (compared to gross domestic product growth of 4.4 per cent), with consumer lending up 40 per cent, while corporate loans grew 17 per cent and mortgages by 25 per cent. Corporate bond issuance hit an all-time high.

For consumers, interest rates went down. For example, Banamex proudly re-entered the mortgage market offering a 12 per cent fixed rate for 15 years, denominated in pesos – an unimaginable product for Mexicans who can remember suddenly being asked to pay interest rates of more than 100 per cent, less than a decade ago. Other banks have reduced the rates they charge on credit cards, the products that should, theoretically, be most sensitive to changes in short-term rates.

This disjunction demonstrates that the Mexican banking market is still immature. Credit has been so limited, leaving such a large proportion of the population untouched, that banks – now with clean balance sheets and a graft of expertise in credit management from their new foreign owners – can expand credit and reduce rates, even as base rates rise.

This will not last for ever. But it is still some years until a rise in rates by the central bank will immediately prompt Mexicans to grouse that interest payments will go up. Even with an election approaching, that suggests the time for an official reference rate is at hand.

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