This week I spoke at the Agora Financial Traders seminar in Puerto Vallarta, Mexico. After the seminar, I headed to Mexico City to do some research on a few Mexican stocks that have recently caught my attention. Not only did I learn a lot about the Mexican economy on this trip, I also discovered that there exists what I call a “gray market” for the American dollar.

I was in the Mexico City suburb of Coyoacan, a colonial residential area lined with cobbled streets and picturesque haciendas. Famous artists like Frida Kahlo and Diego Rivera lived here. My taxi driver was driving around the central square in Coyoacan trying to find a bank since I needed to change some American dollars to Mexican pesos.

Unfortunately for me, it is Holy Week in Mexico, leading up to Easter Sunday, and all banks were closed. The taxi driver suggested I go to the central square and buy something from one of the street stalls. If I paid in dollars, I would get change back in pesos.

The square was bustling with life. There was a stone fountain right in the center and people sat around it eating and laughing. Tiny stalls sold every imaginable thing. One vendor sold large squares of cassava chips, another sold balloons.

A little stall by the fountain caught my eye. A native Indian woman with beautiful bronze skin sat behind her wares. She was selling a brilliantly colorful array of beads. There were bracelets, necklaces, belts, coin purses…all made from beads and by the woman herself.

I picked a red and gold beaded coin purse. After a quick bargain, I managed to get it for $3 (down from $6). The man in the next stall spoke English and translated for me. He explained that the woman is from the Sierra Madre Mountains and her people are Aztec descendants.

I handed the woman a $20 bill. “That’s too large. I don’t have that much change, I have to ask someone else,” she said. Then she took the crisp $20 bill that my Bank of America ATM in Baltimore had spat out just a few days earlier. The woman held the bill up to the sun light and squinting, she inspected it suspiciously.

The man from the next stall laughed, “Don’t make a fuss, do you really think it’s a fake dollar? Just give the lady her change.” I got back 170 pesos. And this is where the gray market comes in. You see, in the international currency market, $1 equals about 10.60 pesos. But here on the streets of Mexico, $1 equals 10 pesos.

Now, let me show you what that means…

So the woman selling beads sold me the purse for $3, when the international currency markets really value it only at $2.83. In the “gray market” on the streets, the going exchange rate is $1 for 10 pesos. But at the end of her day, when the woman takes my $3 to the bank to exchange it for pesos, she won’t get the street rate. She will get the higher, formal exchange rate of $1 for 10.60 pesos. That means she walks away with 31.8 pesos instead of 30 pesos.

That’s a profit of 1.8 pesos just because of the difference in exchange rate between the market on the streets and the formal currency market! I call this the gray market for the U.S. dollar because it is not a black market. At the same time, the U.S. dollar isn’t legal tender in Mexico. So a sort of secondary or informal market exists in Mexico, where the U.S. dollar is worth 10 pesos.

The Mexican economy is highly (but not officially) dollarized — everyone from taxi drivers to street vendors to restaurants will accept U.S. dollars. And like the woman at the bead stall, they will all take U.S. dollars for 10 pesos and then exchange it at the bank for 10.60 pesos. No wonder Mexico is one of the most dollarized economies in the world.

What exactly is dollarization? It occurs when countries officially give up their own currency and start using the U.S. dollar instead. Argentina considered dollarization soon after its currency crisis. Argentina is now 65% dollarized, Peru 85% and Uruguay is about 75% dollarized. Mexico, however, is informally dollarized, as I’ve explained above.

Several countries and regions are already officially dollarized (either fully or partially), like Ecuador, Cuba, Guam, Northern Marianas, Puerto Rico, US Virgin Islands, American Samoa, Marshall Islands, Micronesia, Palau and Panama. Interestingly, countries don’t need U.S. permission to dollarize.

Countries dollarize their capital systems in order to avoid instability arising from their own currencies. If a country uses dollars, it won’t be able to print more if its own currency, so that’s one way of controlling inflation. But full dollarization has its disadvantages. Since the legal tender is not the local currency anymore, reserve banks and policymakers have diminished roles and lesser monetary control. Also, the dollarized country loses its seigniorage (the profit made from printing money). 

Unofficial dollarization, like in Mexico, is more common than full official dollarization. But will Mexico give up its peso and officially dollarize? I don’t think it will, and I don’t think it should. Former president and CEO of the Federal Reserve Bank of Dallas, Robert McTeer, explains why Mexico doesn’t need formal dollarization: “Mexico not only has not had a hyperactive central banker in recent years, but [it]…has grown larger and more stable. NAFTA has accelerated growth, and Mexico has surpassed Japan as the United States’ second-largest trading partner — second only to Canada. I’ve always believed in ‘If it ain’t broke, don’t fix it’…”

Regards,

Sala Kannan
April 14, 2006

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