Nearshoring diversification is sound supply chain strategy

By Jamie Adams

It’s little surprise that the decision makers behind America’s foreign investments are increasingly flocking to Mexico. The world has seen a tidal shift in trade activity as Washington and Beijing carry on their trade war, making imports of China-origin goods increasingly expensive and new investments in overseas production riskier than ever.

Mexico has now usurped China as America’s largest trading partner, exchanging $798 billion in merchandise goods across the southern border, versus $573 billion exchanged between the U.S. and China. The shift isn’t surprising. Mexico’s labor is today more cost-effective than labor in China where wages have grown substantially since China’s entry into the World Trade Organization in 2002. Mexico offers a growing contingent of skilled labor and close geographic proximity to the U.S. The icing on the cake is duty-free trade with the U.S. through the U.S.-Mexico-Canada Agreement (USMCA).

For all these reasons and more, investors have made Mexico the new darling of globally integrated supply chains. Foreign direct investment in Mexico has soared with $13.5 billion flowing into Mexico from the U.S. alone in the first three quarters of 2023. The bulk of the investment is going to critical industries such as transportation equipment and auto parts, electronics, machinery and equipment, furniture, household appliances, medical devices, according to Banxico, the country’s central bank. To further bolster investment, Mexico’s government introduced in October 2023 new laws that would give tax breaks to foreign companies making investments in semiconductors, automotive, electrical and electronic equipment, medical devices and pharmaceuticals, agribusiness, as well as human and animal food.

A New Trade and Investment Landscape

American firms aren’t the only ones taking notice of Mexico’s inherent advantages in the new global trade landscape. Canada, a critical trade partner, has also contributed $2.2 billion, though this was dwarfed by investments from China, which totalled $6.6 billion. The latter are being influenced by two primary drivers. The first is Beijing’s long-term vision for its trade with the world vis-à-vis the Belt and Road Initiative (BRI) that has seen China pump hundreds of billions of dollars into infrastructure investments around the world to ease trade between itself and key partners. The second is Beijing’s desire to help State Owned Enterprises (SOEs) find a way to circumvent the Section 301 tariffs placed on Chinese goods entering the U.S. by setting up shop in Mexico so they can export the goods to the U.S. from there.

To be sure, China’s interest in Mexico isn’t new and well precedes the onset of the U.S.-China trade war. In fact, China’s exports to Mexico have grown from just shy of $10 billion in 2003 to $126 billion in 2022, much of which is made up of intermediate goods that are incorporated into finished goods or more advanced intermediate goods that are eventually exported to the U.S.

Why does the U.S. election matter?

Mexico’s rise to the top of the U.S.’s trade-partner list is partially the result of a relatively hands-off approach by the Biden administration and the United States Trade Representative’s office with respect to Mexico’s economic and trade policies.

Through the Biden administration’s term in office, the U.S.-Mexico relationship has been primarily characterized by security-related issues in the form of drug cartel violence and the migrant crisis. Under-the-radar issues, such as Mexico’s move to nationalize its energy sector, disputes over agricultural products like tomatoes, and progress toward meeting its USMCA obligations in labor policy, have generally been just that —— under the radar.

But the looming election has seen the Trump campaign take a much harder line on Mexico with respect to trade. There have already been suggestions that a 10% universal tariff could be in the cards should Trump reclaim his residence at the White House, not to mention a 100% tariff on any Chinese EVs making their way into the U.S. It’s important to remember that the recent rise of trade protectionism in the U.S. began not with China as the boogeyman but Mexico. It was Mexico that the 2016 Trump campaign had claimed was taking away jobs and driving the Rust Belt’s de-industrialization. It was trade with Mexico the campaign said needed to be revisited by renegotiating NAFTA. And all this during a time when Mexico was being led not by a progressive-left president, but a centrist with anti-corruption agenda.

There’s little reason to believe the Trump administration would not once again set its sights on Mexico, especially since it’s become a critical point of transshipment for Chinese goods. That means either directly taking Mexico City to task for any real or perceived transgressions, or asking it to crack down on Chinese transhipment. A little further down the line, Washington will have the opportunity to re-open the discussion of just how beneficial the USMCA has been to the U.S. economy when the trade deal comes up for review in 2026. At that point, Washington can choose to put forward additional requests for reform that Canadian and Mexican policy makers may have trouble swallowing. Failure to come to mutually agreeable terms could see the agreement disbanded (albeit an unlikely scenario at time of writing) or certain amendments put in place that could make cross-border trade less advantageous. In addition, political issues such as the border crisis could further inflame tensions between the two countries.

U.S. political considerations aside, there are drawbacks to over-reliance on Mexico. Security is a constant concern as is infrastructure, particularly in the country’s northeast region. Improvements to infrastructure and other investments that may benefit economic output aren’t likely in the near term as the government’s revenues relative to GDP are the lowest in the OECD. Lastly, as affordable as Mexico’s labor is, there are limits to the pool of high-skilled labor and much of the labor force remains outside of the formal economy.

On a more technical note, some U.S. companies are making the mistake of using Mexico as a transshipment point for Chinese goods without substantial transformation. In other words, goods are being imported into Mexico from China, modified only slightly and then re-exported to the U.S. as Mexican goods with duty exemption through the USMCA. In the customs world, this is what’s referred to as unsubstantial transformation and firms using this practice will soon find themselves on the watch list of U.S. customs and facing the ominous penalty of retroactive duties, not to mention fines and penalties, and potentially the loss of import/export licenses.

What’s an investor to do?

There’s no crystal ball that allows us to determine precisely how things will play out in the upcoming election and how a President Biden or President Trump will engage with Mexico and on what timeline. What we do know is the lesson learned from the pandemic, which is not to rely too heavily on any one source of supply. In short, the solution to over-reliance on China is not over-reliance on Mexico.

Firms engaged in nearshoring should consider diversifying their sourcing and strategically locating their U.S. production facilities to take advantage of the geographic proximity of both Mexico and Canada.

One need only look at the funds being invested by U.S. companies in Canada versus Mexico to see there’s strong logic to setting up shop north and south of the border. With all the fuss being made about Mexico as the alternative to China and the shift to nearshoring, U.S. investment in Mexico in 2023 capped out at $13.76 billion, compared with $35.5 billion being invested in Canada, more than double.

The key is to distinguish where it makes sense to invest in one over the other based on the advantages each has to offer. Canada is increasingly making a name for itself in sustainability with 35 new projects in 2023 alone, a 21% increase from the previous year. Sustainable projects now represent 29% of total FDI stock in Canada (from all sources, not just U.S.).

Much of the investment is being funneled into the country’s manufacturing sector and is heavily weighted toward automotive production. That’s because the country boasts a highly skilled workforce, more than one-third of which is made up of professional, scientific and technology related jobs. In addition, it has a regulatory system that is well-harmonized with that of the U.S. The geographic proximity of Canada’s Golden Horseshoe region in southwestern Ontario to America’s Midwest industrial centers is another critical consideration. For all these reasons and more, Canada’s economy has been tightly integrated with that of the U.S. Pre-pandemic figures show 50% of Canada’s intermediate goods exports going to the U.S.

The critical questions?

Determining when, where and how to invest will, of course, depend on the aforementioned investment and political climate, which no one can predict. But as a general guide, healthy nearshoring along America’s northern and southern borders would consider the following:

  • What type of goods are being moved across the border – raw materials, intermediate goods, finished goods, etc.?
    Customs officials will evaluate these differently based on their classification and their proportionality with respect to regional value content requirements.
  • Is the end market the U.S. or global? If the former, where in the U.S.?
    If the goods are being re-exported to global markets, firms may want to consider free trade zones as alternatives for duty-free manufacturing.
  • What is the value of the product?
    High-end goods with high price tags and/or high levels of fragility will require multiple considerations, including roadway infrastructure, temperature control, time in transit and security.
  • What is the complexity of the product?
    Goods requiring high-skilled manufacturing can leverage either the U.S. or Canada, but Canada boasts a larger high-skilled workforce and certain specializations that may appeal to certain industries.
  • Is transshipment involved?
    Goods coming into Canada or Mexico from abroad and then exported to the U.S. will require substantial transformation to qualify for USMCA duty exemption.

For many firms, Canada may seem like a non-starter given the substantially higher labor rates and lower levels of labor productivity. But higher labor costs are often neutralized by reduced time in transit, harmonized regulatory practices that prevent delays in getting to market, reduced security incidents that delay or cancel shipments, et al. This is not to discourage investment in Mexico. On the contrary, there are a multitude of good reasons to make Mexico a production center, not least of which is its growth potential. But diversifying nearshoring production allows a company to hedge its bets, and as we’ve all learned in recent years, that’s sound strategy in any supply chain.

Jamie Adams has extensive and diverse experience in compliance with relevant domestic and foreign import and export laws, as well as in creating and executing plans to improve global trade and international supply chain programs and systems.