It’s been a hard year for the UK manufacturing sector. Amidst rising inflation, persistent supply chain problems and increased red tape as a result of Brexit, many manufacturing firms have had to constantly adjust their operations to navigate an uncertain environment.
Between July and October, confidence amongst manufacturers fell at its fastest rate since April 2020 – the onset of the pandemic – whilst output in the sector also fell to its lowest level in nearly two years.
One of the most serious, yet often overlooked challenges facing the industry is the threat of negative currency movements. Although we may not typically associate the manufacturing sector with foreign exchange (FX), FX forms an essential component through which manufacturers trade and do business. As of 2020, there are approximately 300,000 UK manufacturers importing or exporting overseas, meaning the industry is highly susceptible to the impacts of FX volatility.
Despite this, many manufacturers may traditionally see the task of FX risk management as second order. They transact in FX not because they ‘want’ to, but because they ‘have to’ given their international coverage.
However, with FX volatility set to persist into 2023 and beyond, we believe it is vital that manufacturers have effective FX risk management strategies in place to mitigate the impact of currency exposures.
What are the FX challenges for manufacturers?
Supply chains are typically global by nature, meaning manufacturers that export and import goods to and from other countries are especially exposed to the risks associated with exchange rate fluctuations.
The weak Pound is putting pressure on manufacturers that source components from outside of the UK by making imports more expensive. This is especially problematic for firms that purchase large quantities of components and raw materials overseas. Automotive manufacturers, for example, on average buy 60% of their parts from abroad and assemble them in the UK, meaning they run a particularly high risk of being negatively impacted by currency fluctuations.
This has forced many manufacturers that import from overseas to evaluate the effectiveness of their hedging strategies.
Many have been left unsure how to hedge effectively while still maintaining some form of flexibility, as they look to boost their profit margins in light of the recent historical lows of the pound and euro. Instead of locking in rates for 12 months or more, businesses are moving towards shorter hedging periods of 6 months or less, giving them flexibility to adapt to a changing market.
Implementing a strategic approach to FX risk management
With headwinds and inflation set to persist throughout the year ahead, we believe manufacturers must begin implementing a robust risk-management strategy to minimise their exposure to foreign currency movements. Fortunately, there are a number of steps that manufacturing firms can take to achieve this. These include:
Compare the market - having the ability to put trades up for competition is central to ensuring access to the best price, which is key to effective risk management. However, many manufacturing firms may be hampered by their inability to access Tier 1 FX liquidity, meaning they often rely on a single bank or broker to meet their hedging requirements. A new generation of FinTech businesses are tackling this problem, enabling insurers to access rates from multiple banks whilst reducing the operational burden associated with this kind of market access.
Use of Transaction Cost Analysis (TCA) - TCA was specifically created to highlight hidden costs and enables manufacturers to understand how much they are being charged for the execution of their FX transactions. Ongoing, quarterly TCA from an independent TCA provider can be embedded as a new operational practice to ensure consistent FX execution performance
Outsourcing - there is a growing recognition that outsourcing does not necessarily mean less transparency or reduced quality of FX activities, but when using the right partner can improve transparency and execution quality. Outsourcing can enable manufacturers to dedicate more time to core business matters, which is all the more important amidst inflationary and volatility pressure.
Strong governance – Supply chains are complex and include several steps. These include the sourcing of raw materials, manufacturing these materials into basic parts, refining basic parts into finished products and selling finished products to end users. It is therefore difficult to increase transparency due to the number of different partnerships and processes in the trade network. Harnessing solutions which can strengthen governance will help manufacturers improve the cost, quality and transparency of their FX execution.
Manufacturers have faced a constantly changing market in 2022, and with currency movements set to remain volatile over the next year, FX risk must no longer be considered second-order. Harnessing technology-driven tools and getting the right processes in place will help enable manufacturing firms to navigate mounting FX challenges and protect their bottom lines.