MEXICO CITY (Reuters) -- Inflation is falling, interest rates are easing and
                  Mexico's central bank is repairing its credibility, but economists warn that
                  the peso's unforeseen strength cannot last.

                  Mexico's fickle peso, which just four years ago unleashed the country's
                  worst recession since the thirties when it devalued about 40 percent, has
                  surprised economists by shrugging off Brazil's financial crisis to appreciate by
                  about 8.0 percent since January.

                  On Friday, it closed at a seven-month high of 9.507 pesos per dollar,
                  boosted by strong capital flows as investors distinguish Mexico from the
                  Latin American pack.

                  "The peso is quite frankly stronger than any of us were expecting at this
                  time," said Fernando Losada, senior Latin American economist at ING
                  Barings.

                  "But what is good for fighting inflation can become a problem for the balance
                  of payments. If it is this strong in the next two to three months, that will be
                  too much and we would start to see the trade balance deteriorate."

                  Banco de Mexico is probably thrilled by the current good fortune -- the
                  strong currency means the country is importing less inflation, helping bring
                  the consumer price index down.

                  Last year, the bank's credibility was torpedoed when inflation hit 18.61
                  percent, nearly 7.0 percentage points higher than the official 12 percent goal.
                  And repairing its reputation looked difficult after public sector price rises in
                  January had economists again posting forecasts well above the 13 percent
                  target for this year.

                  But now, thanks chiefly to capital inflows that have driven the peso's
                  strength, private and official inflation expectations are starting to coincide.
                  Meanwhile, interest rates have eased to just over 22 percent from 32
                  percent in February after the Brazilian crisis hit.

                  "The odds are (Banco de Mexico governor Guillermo) Ortiz will win his
                  battle against inflation," said Chip Brown, Latin American economist for
                  Morgan Stanley Dean Witter in New York. The company revised its
                  inflation forecast to 14 percent from 16 percent two weeks ago.

                  But economists say the peso is already some five percent overvalued and the
                  trend will have to reverse before year-end.

                  "The key point is that Mexico has an election next year and it doesn't want
                  to go into 2000 with an overvalued currency," Losada said.

                  Neil Dougall, chief economist for Latin America at Dresdner Kleinwort
                  Benson, agreed a change was due, although he said the peso could continue
                  at current levels for some months.

                  "The exchange rate is already at a level where competitiveness concerns are
                  starting to mount," he said in a research note.

                  "Although we are now expecting a stronger peso at the end of this year than
                  previously -- 10.9 to the dollar compared with our prior forecast of 11.4 --
                  this still implies a significant correction from current levels."

                  Finance Minister Jose Angel Gurria began talking the peso down in
                  comments at the Inter-American Development Bank meeting in Paris this
                  month, saying he expected the peso to depreciate 10 to 11 percent this year,
                  in line with the U.S. inflation differential.

                  But economists say that, if the peso continues at current levels, Banco de
                  Mexico will have to start signalling it wants it to weaken -- either by relaxing
                  its tight monetary stance, or increasing the size of its dollar put options,
                  which soften the peso by soaking up greenbacks.

                  "What you don't want is to see your trade balance deteriorating first,"
                  Losada said.

                     Copyright 1999 Reuters.