Cross-Border

The Rise of Nearshoring: What it may mean for Financial Planning and Analysis teams, Treasury teams, and CFOs

CalendarMarch 15, 2024
EmailTwitterLinkedin

The Rise of Nearshoring:

What it may mean for Financial Planning and Analysis teams, Treasury teams, and CFOs

Nearshoring –moving manufacturing, supply chains, and services closer to home—has been on the rise since the COVID-19 pandemic. Rising labour costs, supply chain disruption, and the long COVID lockdowns in China accelerated this shift. In July 2023, Mexico passed China as the United States’ leading trading partner and source of goods.

This shift has many positives, but it also presents some challenges for financial professionals. Historically, using third parties to produce goods in China was relatively simple, as exporters tended to prefer receiving payments in US dollars (USD). This does not eliminate exposure to currency market volatility, but it may hide it.

Importing from a factory in Mexico is a different story. The Mexican peso (MXN) is a freely traded currency, increasing the likelihood that vendors will request payment in their local currency. This converts what was once an indirect currency exposure on a business’ P&L or balance sheet into a direct FX exposure that now must be accounted for. Other practical considerations include opening MXN-denominated bank accounts for subsidiaries in Mexico that are partially or fully owned, as well as understanding the local regulatory regimes. Further, the Mexican peso is historically much more volatile than the tightly controlled Chinese yuan.

That said, there are potential upsides to operating in Mexico, and taking advantage of those while addressing new FX exposures can be quite straightforward. In this and in the next article, we will explore these further.


Good neighbors

Nearshoring—the movement of manufacturing capacity and supply chains closer to end users—become more since the disruption brought upon by the Covid-19 pandemic.

This trend has now become a reality as manufacturing investment in the United States and imports from Mexico have risen sharply, with Mexico’s factories now displacing China’s as the US’ leading source of imported goods.

There are several factors driving this development. Predominant amongst them is the relative ease of doing business in Mexico, supported by proximity and similar time zones, and a long history of integration into the North American trade bloc via NAFTA (signed in 1992), and NAFTA’s successor USMCA (which went into effect in 2020). Rising labour costs in China, as well as growing trade disputes and China’s prolonged COVID-Zero policy, underscored the growing challenges and risks of conducting trade far from home.

Frequently not mentioned, but also a very important factor, has been the considerable rise in manufacturing investment in the United States itself. Driven in large part by the CHIPS and Science Act and the Inflation Reduction Act (IRA) passed by the US Congress in 2022, manufacturing investment in the United States is hitting highs not seen since WW2. Given the close integration of the US and Mexican economies, Mexico is also a beneficiary of this trend.

The Proof Is in the Pudding

Gamechangers – FP&A and Treasury Implications

While this re-alignment is a compelling economic story, this post focuses on the practical implications for finance teams.

Key amongst those implications is the conversion of a frequently ignored indirect exposure to FX risk into a direct, and potentially larger, exposure. As mentioned earlier, the Mexican peso’s price is largely set by the market as it is a fully convertible currency with no capital controls. Additionally, the Mexican banking sector is much more globally integrated than China’s.

This reduces a lot of the headaches around cash management, pooling, concentration, and payments that existed with carrying out business in China. A key tradeoff, though, is the introduction of a lot more exposure to currency market fluctuations: fluctuations that are more likely to show up as direct impacts to financial performance even for businesses that are simply engaging with third party vendors in Mexico.

SOURCE: Bloomberg

Chart: Corpay Cross-Border

These challenges rise from differences between Mexico and China, such as:

  • Third party vendors in Mexico are more likely to invoice customers in Mexican pesos (MXN). The Chinese yuan (CNY) has limited trade outside of China due to government-imposed capital controls. This is not the case in Mexico; accepting MXN is typically the preference for Mexican businesses conducting global trade, and there is not the same desire to maintain USD reserves in Mexico as there may be in China.

  • The Mexican peso is more volatile relative to the CNY. The MXN freely floats other currencies with limited intervention by the Banxico (Mexico’s Central Bank). The People’s Bank of China (PBOC) ends to intervene frequently in currency markets to suppress two-way movement in the yuan.)

What does this mean for financial decision makers? It comes down to FP&A

Fortunately, the banking system and derivatives markets in Mexico and for the Mexican peso are relatively liquid, deep, and mature. From a pure treasury perspective, hedging MXN risk or accessing local MXN bank accounts can be a straightforward and efficient exercise.

A key challenge arises in the change in budgeting that may need to take place. While logistically there can be significant cost advantages to working closer to home, the higher variability in the Mexican peso and the higher probability it will show up directly on budgets mean that considering FX risk in the FP&A process becomes much more important.

FP&A in Application

Methods for identifying, budgeting, and analyzing MXN currency exposure can vary depending onhow the exposure comes to the business.

Third-Party Vendors

Mexican companies are more likely to bill in their local currency than Chinese companies are in theirs. This increases the probability of direct FX exposure on a business’s expense line items and Accounts Payable (AP) ledger.

  • MXN is an easy exposure to capture, as it will show up directly on the invoice or in the early stages of the procurement process.

  • Forecasted exposures – Captured and aggregated directly in the beginning stages of procurement/contracting processas it will have to be built into 13-week cash forecast if one exists.

  • Balance Sheet Exposures – From the aggregated Mexican balances sitting on the AP ledger if your accounting system has multicurrency reporting. Can be backed into by identifying balance sheet items that are flagged for monthly remeasurement.

Fully or Partially Owned Subsidiary / Joint Venture

  • This exposure is not as easy to identify, particularly if FP&A and treasury functions are not centralized.

  • For a business importing from either China or Mexico, no matter what, there is FX risk exposure that can impact financial performance. It is just a matter of where and how material it is.

  • Here are key areas to examine to identify exposures.

  1. Intercompany transactions - if the subsidiary (in Mexico or China) is paid in USD but operates in MXN, then the subsidiary’s books are exposed to FX risk. Currency market volatility can impact income statement and then get rolled up on consolidation. In the opposite situation, where the parent is paid in MXN or other currency, the parent’s books are exposed directly to FX risk.

  2. Working capital items flagged for remeasurement – In a situation where neither entity has foreign currency revenue or expenses that perfectly offset each other in timing or amount, there is exposure to a net asset or liability balance sheet entry that gets remeasured and recorded as a gain or loss on P&L.

  • Accounting and ERP systems usually flag working capital items that are scheduled for remeasurement on each reporting cycle.

  • Taking the gain/loss for each of these into account against the FX spot rate movement over the corresponding period can help identify the size and direction of the currency exposure in the entity.

Exposure Identified! Now what?

As children of the 1980s may remember from G.I. Joe, knowing is half the battle. We’ve now discussed FX exposure in terms of size and position. In the next piece we will go over some of the tools (and potential opportunities) specific to hedging MXN currency that can help mitigate risk when used prudently by FP&A and treasury teams.

Opinions expressed in this article are those of the author. Please consider contacting an independent advisor of your choosing – an advisor completely independent of Corpay – to help you ensure that solutions discussed here are right for your business’ needs.

The hedging products described in this document can be useful but are also associated with significant added complexity; obtaining a thorough understanding of each such product's trade-offs/pros-and-cons (fully describing these is beyond the scope of this article) is important before choosing to use any of these products.

Additional resources

Subscribe to our Market Commentary

Explore our Currency Research site

Connect with Sean

Author

Sean Coakley, CFA

Sean Coakley, CFA

Director, Strategic Sales, & Market Strategist

Sean works with mid-market corporates, focusing on FX risk management and international working capital optimization. He blends experience in finance and capital markets with a robust understanding of business performance and capital markets knowledge.

EmailTwitterLinkedin