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The exchange rate in Mexico and its effect on manufacturers

The exchange rate in Mexico and its effect on manufacturers

Tecma executive vice president and CFO, Mark Early, explains how the exchange rate in Mexico affects manufacturers.

The Tecma Group of Companies:

Hello and welcome to another installation of Tecma Talk podcasts during which we speak with experts that are both internal and external to the Tecma Group of companies about issues that have to do with manufacturing in Mexico. Today, in this particular installment, the conversation is with an internal expert. We’re speaking with the executive vice president and CFO of the Tecma Group of Companies, Mark Earley. Mark, how are you today.

Mark Earley:

I am doing quite well, and appreciate the opportunity to address a highly important topic.

The Tecma Group of Companies:

Mark, if you will give a little background about yourself and then we can get into the topic of discussion of today, which happens to center about the question of how exchange rates in Mexico affect manufacturers. A little background biographical information would be appreciated.

Mark Earley:

I have a little less than thirty years of experience in the maquiladora environment. I lived through some days of what was deemed hyperinflation in Mexico, when we had over one hundred percent inflation, devaluation, a change in currency from the old to the new Peso, to today’ relatively calm currency conversion and, in terms of inflation, single digit similar to the United States. We have seen, however, just recently, a some what significant movement in the Mexican Peso exchange rate.

The Tecma Group of Companies:

That comment is a lead in to the first question. What, in fact, is happening with the exchange rate in Mexico vis a vis the US dollar?

Mark Earley:

Coming out of last year, we had a relatively stable Peso. That’s been the case for the last several years. Looking back at 2014, we see a Peso that traded between about 12.5 and up to about 13.3, and, that is again, against one US Dollar. That was for the majority of the year. In December, we saw a pretty significant movement. The Peso started to trade in the 14:1 range. We had an opening exchange rate in Mexico for the Peso, at the beginning of 2015, about 14.7 to 1 US Dollar. It has been as low as 14.3, and as high as 15 Mexican Pesos to the US Dollar.

What has happened in the recent past that has caused the Mexican Peso exchange rate versus the US Dollar to move so significantly has to do with the fact that a significant portion of the Mexican government’s budget has its source in oil revenues that are received from the state run petroleum company, PEMEX. With the decrease of the value of a barrel of oil down into the forty dollar range, the Mexican government has lost a significant portion of its budget. The market has reacted in a negative way, and that has been the true underlying reason for the Mexican Peso’s weak position against the US Dollar. The Peso has lost value, and, today, the exchange rate in Mexico for the Peso is close to 15:1.

The Tecma Group of Companies:

So, if there has been an impact on the exchange rate in Mexico that would be the result of what you just described on manufacturers in Mexico, what would that impact be from your perspective?

Mark Earley:

If we look at we look at things from the perspective of North American companies, most of them make their sales in dollars. These are companies that produce in Mexico and, subsequently, export their product for sale into other areas of North America, or for companies that produce in Mexico and then sell to other US companies within Mexico. Most of the transactions like this that take place within Mexico are Dollar denominated sales. In this particular case, what we have is a weakening Peso. This has had the effect of reducing costs for the manufacturer and, therefore, the sales price of products in dollars remains the same. Therefore, there are lower costs that result in a higher margin and improved profitability as the Peso devalues.

The Tecma Group of Companies:

If a manufacturer, for instance, is accessing product that is either utilized in the manufacturing process or, in some way shape or form utilized in the manufacturing plant, if there is a hypothetical devaluation of five percent, can those who are using those items expect to see the cost of what they are buying in Mexico decrease by five percent due to the change of the exchange rate in Mexico?

Mark Earley:

From the stand point of the value-add of the foreign nationals producing in Mexico, with respect to labor, yes, for the most part you will experience a 100% impact from that devaluation of 5%. If the exchange rate in Mexico devalues 5% against the dollar, there is a corresponding 5% reduction in terms of labor cost. In terms of a lot of the raw materials that are brought in from the US, or procured from other foreign national companies in Mexico, there would be no reduction in cost due to their being dollar-based in their pricing. A lot of MRO supplies come from either US companies
in Mexico, or from Mexican companies that procure the products from outside of Mexico. We would not necessarily see a one to one correspondence between the devaluation in the exchange rate in Mexico and a corresponding cost savings. There may be a temporary advantage in that a company may have a purchase order in Pesos that would benefit, but, over time, as those parts are foreign-based parts, suppliers would eventually increase their prices in Pesos, as, for the most part, they are buying them with dollars.

The Tecma Group of Companies:

So, to recap, you would see a corresponding savings in labor as a result of the weakening exchange rate in Mexico of the Peso. In terms of MRO, however, as well as other things that you might purchase in Mexico that might be linked to the Dollar, you might not see a 5% decrease in the cost of these items, if a decrease at all. There is one other thing that comes to mind that I would like to ask about: Let’s say at the beginning of the year you contracted for a lease rate that was for twelve months, or whatever the term happened to be, what would the impact of the devaluation
of the Mexican currency be on the negotiated price of manufacturing rental space?

Mark Earley:

One thing we see in Mexico is that the property owners hedge on that. For the most part, the lease agreements for industrial space in Mexico are denominated in US Dollars. There are two ways in which this is done. The first is that you will pay in Dollars for the lease space in Mexico. The other is that is that you will be paying in Pesos, but contractually the rate is set in dollars. On a monthly basis is is converted into Pesos at a published exchange rate in Mexico. In essence, any fluctuation in the value of the Peso is taken into consideration, thus protecting the landlord.

The Tecma Group of Companies:

For companies that are thinking about installing operations in Mexico, and have never been outside of the boundaries of the United States and have not had to take into account exchange related issues, what would you recommend in terms of decision-making, and what would be the basic things to know before making a decision?

Mark Earley:

Those are very good questions. I am going to tackle the first one in terms of considerations that should be made when looking at Mexico as a manufacturing venue. First and foremost the Mexican Peso is at around fifteen to one US Dollar. The movement that we have seen since December is not a market correction. This is a reaction to, again, the price of oil. If we listen to the experts, we can expect that the price of a barrel of oil will rise to somewhere around the seventy to eighty dollar range towards the end of this year. Therefore, we should also see an improvement in the
exchange rate in Mexico of the Peso in terms of its valuation against the US Dollar. The first thing to take into account when contemplating a decision to initiate operations in Mexico is that an exchange rate that is a little more historically consistent should be used. I would not use an exchange rate in Mexico of 15:1. I would use, let’s say an average for 2014. That would be somewhere in the thirteen Mexican Peso to US Dollar range. This is a conservative approach, but, for those companies looking to set up operations in Mexico, if a company does its analysis at at a 15:1 exchange rate it might look good to set up in Mexico. It is better, however, if it looks good using an exchange rate in Mexico of 13:1. At the later rate, its pretty safe to say that if you go toMexico the business case would be justifiable.

Number two is that, as you look to Mexico, there is the ability to hedge the Peso going forward. This can be a difficult process. It is advisable to rely upon experts to do so. In terms of what Tecma does, we do not hedge very far out into the future. We will hedge, and will take the position of up to 50% of the Pesos required to fund our Mexican operations. When we do this, however, we usually do not go over a thirty day period. We don’t hedge for the long term, just in case there are major market adjustments in the Peso that would affect us negatively. As our sales are in US Dollars, any weakening of the Peso is beneficial to us. If it strengthens a little bit, yes, there is a negative impact on us. By selling in Dollars, however, we minimize our currency risk.

The Tecma Group of Companies:

In addition to how a company addresses this particular issue, you might want to also take a look at how the situation is different for a firm that has decided to incorporate itself in country to begin manufacturing in Mexico, as compared to those manufacturers that have opted to work with a shelter company. I would assume that there is a pretty significant difference with respect to those two scenarios?

Mark Earley:

That’s correct. When you take a look at the situation in which you are independent and you decide to establish your entity in Mexico, you are then dealing with financial institutions to go ahead and convert your US Dollars into Pesos to fund the Mexican operation. There needs to be some expertise in this area internally to make sure that companies find a financial institution that is credible in there ability to move funds through. Then a relationship must be established between the US financial institution and a Mexican bank.

In terms of what Tecma does in its shelter operation is to remove all currency fluctuation risk. Tecma invoices and bills its clients in US Dollars. We do allow for the favorability of a devaluation related to the exchange rate in Mexico, because we can take all of our Mexican expenditures that are made on behalf of our clients and convert them at a published rate. We convert the expenditures to US Dollars and invoice our US clients according to the published rate of exchange. From a currency perspective, all movements of money are done within the United States from our clients’ US bank accounts to Tecma’s bank account. There is are no requirement to move money from our client to the Mexican operation. That is what Tecma does. Tecma takes its clients’ US Dollars and moves them to its Mexican banking institution. That is probably the easiest thing. Also, when you look at things from an accounting perspective, there is no need to deal with or have experience in dealing with multiple currencies. The currency that you have remains the Dollar. Tecma takes on all of the additional burden that comes accompanies dealing with multiple currencies. Our clients are able to do the entirety of their accounting in Dollars, or in whatever is their functional currency.

The Tecma Group of Companies:

There are a couple of fairly brief questions that I’d like to ask to round out the discussion:

Firstly you had mentioned that in anticipation of oil returning to a price of around eighty dollars per barrel, the Peso would get somewhat stronger as oil moves in that direction. Are there any other things that you can anticipate with respect to the future of the exchange rate in Mexico?

Mark Earley:

The exchange rate of the Peso is free floating. This last major movement happened as the result of a lose of value in a barrel of oil. In the past we have seen elections move the Peso. We have seen unrest affect the exchange rate in Mexico. It’s free floating, but, I think, if we take a look over the long term and what the experts are telling us is that they expect the Mexican economy to continue to grow in strength. They also have the expectation that the Peso with strengthen versus the US Dollar, as well as against other major currencies worldwide. This will be a very slow movement. My expectation is that, in the future, we will see the Peso come back down when oil rebounds into the range of thirteen Mexican Pesos to US Dollars. We will see this happen within the
next thirty-six months.

The Tecma Group of Companies:

Mark, this has been a relatively brief discussion on a topic that has more nuance than we can address during a conversation of fifteen or twenty minutes. If there are individuals, or representatives of companies that would like to tap into your expertise due to years of having to deal with this issue, how can they contact you with questions?

Mark Earley:

There are two ways that this can happen: The easiest way is to go to the www.tecma.com website. People can fill out the contact form there to reach me. I can be contacted directly by email, as
well, at mark@tecma.com.

Remember, relevant and useful Mexico manufacturing content is available at one’s finger tips by downloading the Tecma Group mobile app from the Google Play Store, interested parties can also receive Mexico manufacturing information on a weekly basis by SMS Texting the word Tecma to 96000.

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