Emerging Markets Beckon World Carmakers
Imagine a rapidly growing economy in which billions of increasingly affluent citizens cannot wait to buy their first car and take to the freedom of the open road. No, this isn't a multinational auto executive's fantasy: it is the reality of China and India. As demand starts to stagnate in the West's mature and saturated automotive markets, the East's full growth potential is becoming apparent to the world's carmakers.
In China and India, with populations of 1.3 billion and 1.1 billion, respectively, fewer than 10 in 1,000 driving-age inhabitants currently own a car. Yet purchasing power in these two countries is strengthening significantly, as shown by 2006-2020 GDP growth forecasts of 5.5% per year in India and 5.2% per year in China.
The situation is less enticing in Russia, where vehicle ownership is about 160 per 1,000 driving-age inhabitants in a total population of 143 million. With an improving economy and continuing expansion of disposable income by between 9% and 14% per year over past six years, however, the Russian market also offers above-average potential for the automotive industry, despite significantly lower projected GDP growth than in the other two emerging markets. Also, as more than 50% of Russia's existing car fleet is more than 10 years old, replacement requirements will likely be high there in the near future.
Auto Sales Are Picking Up Speed
A snapshot of the past five years tells a story of sales that have already moved into the fast lane. The Chinese automotive sector grew by 60%-70% per year between 2001 and 2004. After cooling down in early 2005, when the government increased interest rates to control demand, the market picked up again in the second half of 2005. We therefore continue to expect an average growth of at least 10%-15% per year over the medium term, and Global Insight Inc. forecasts suggest that China will become the world's second-largest automotive market by 2013.
After China, the Indian car industry is the second fastest-growing automotive market, currently totaling about 8 million vehicles. India is still dominated by motorized two-wheelers, but passenger cars represent a high-growth segment. After double-digit growth in 2003 and 2004, passenger-car sales expanded by a more modest 5.2% between April and November 2005. Market growth forecasts, however, suggest a rate of about 10%-12% in 2006, which matches long-term economic growth expectations in India. Auto sales are being stimulated by new product launches, growing interest in diesel vehicles, low interest rates, greater access to consumer financing, and a reduction in local taxes, which still account for about 30% to 40% of the total selling price of a car.
In contrast to China and India, Russian car sales have grown at a more modest 7%-8% per year since 2000, and customers are increasingly opting for more expensive cars. The average selling price has increased by approximately $1,000 per year over past three years, which has further boosted sales revenues. Market revenue has doubled over the past three years to $22 billion in 2005, and it could grow further if conditions, such as high oil prices, remain in place. Unlike in many other countries, Russia's population benefits when oil prices are high, stimulating car sales, and this positive effect is far from offset by increasing domestic gasoline prices, which the government keeps at a low level.
Competitors Crowd the Chinese Market
The furthest developed of the three large emerging markets, China's automotive industry is also the most fragmented. Every major international manufacturer is present through imports and, increasingly, with local assembly and production plants, which are generally owned in conjunction with local joint-venture partners. Although the country boasts more than 100 auto manufacturers, only a few companies----including the market leaders First Automotive Works Group (FAW) and Shanghai Automotive Industry Corp. (SAIC)--produce more than 500,000 units per year, including commercial vehicles.
Germany's Volkswagen AG (VW; A-/Negative/A-2) was the first foreign carmaker into the Chinese market nearly 20 years ago. It has managed to retain its leading share since then, although the trend is declining. Sales growth has slowed in recent years, and Volkswagen's market share has plummeted to a mere 17.3% in the first nine months of 2005 from nearly 60% in the mid 1990s, reflecting the increasing pressure VW faces from new products in the middle segment of the market, in which it has traditionally been strongest.
The U.S.'s General Motors Corp. (GM; B/Negative/B-3) has also been one of the big movers in China. Through its six joint ventures, GM is well positioned to capitalize on recent rapid growth in the Chinese market, and the company is in the process of significantly increasing its production capacity in China. GM's Regal and Excelle models have managed to take sales from VW's Santana, Bora, and Audi. GM is now No. 2 in the market, with a 14% share. Other large foreign manufacturers in China include Toyota Motor Corp. (Toyota; AAA/Stable/A-1+), Suzuki Motor Corp. (A-/Stable/--), Honda Motor Co. Ltd. (A+/Stable/A-1), Peugeot S.A. (A-/Stable/A-2), Ford Motor Co. (BB-/Negative/B-2), Nissan Motor Co. Ltd. (BBB+/Stable/A-2), and Hyundai Motor Co. (BBB-/Stable/--).
Local Players Still Dominate in India
The fledgling Indian car market is still more concentrated than China's, although foreign players are taking a growing interest. Indian automaker Maruti Udyog Ltd. (MUL; not rated), which is 54% owned by Suzuki Motor Corp., dominates, with a market share of about 50%. At present, it specializes on the small-car segment, but it has strong plans to penetrate the medium- and large-vehicle segment in the near future.
The next-largest players are Hyundai Motor India Ltd., a subsidiary of Korean Hyundai Motor Co., and India's own Tata Motors Ltd. (BB/Stable/--). In the fiscal year ended March 31, 2005, Tata Motors held the largest market share in midsize entry-level sedans (Indigo) and the third position in the compact-car segment. Tata Motors has been able to offset some of its loss in market share in the compact-car segment with rapid gains in the entry-level sedan category. Tata Motors scored these gains because of its ability to introduce diesel versions of these cars. Finally, Honda Siel Cars India Ltd., a joint venture between Japanese Honda Motor Co. Ltd. and Siel Ltd., is the fourth-largest player in the Indian market.
Foreign Companies Make Inroads in Russia
The growing Russian market has presented a wealth of opportunity for both domestic and foreign producers, but foreign carmakers are taking the largest slice. This is mainly because domestic producers largely lag most international peers in terms of product quality. In the past, Russian carmakers have retained their market positions through cost advantages, given the still price-sensitive demand and somewhat aggressive political lobbying, as exemplified by the introduction of high import duty on used cars and components in 2003.
However, the strengthening ruble and increasing disposable income combined with declining prices of foreign brands assembled domestically are eroding the cost advantage of domestic carmakers, which have been losing market share rapidly over the past two years. From a dominating 60% of all cars sold in 2003, Russian manufacturers fell to less than 50% at the end of 2005.
Notwithstanding its gradual loss of market position, AvtoVAZ remains the key player in the Russian passenger-car market, with a 38% market share in 2005. All other domestic producers account for less than 6%. The remaining share belongs to foreign cars, where the proportion of used cars over new vehicles has been declining. Over the coming decade, foreign brands produced in Russia and new-car imports will gain in importance, putting domestic automakers under increased pressure.
China Emerges as a Key Manufacturing Region
The Western automakers' invasion of the East is changing the landscape of global auto production. Although three-quarters of vehicles are manufactured in the three key production regions of North America, Western Europe, and Japan, China has now overtaken South Korea and France to become the fourth-largest auto manufacturer in the world. In terms of commercial vehicles, it is the third-largest producer behind the U.S. and Japan. In the first 10 months of 2005, total production amounted to 4.6 million vehicles, with passenger cars now exceeding the number of commercial vehicles built. Massive capacity build-ups in the Chinese market could result in a total installed production capacity in excess of 12 million units by the end of the decade.
An increasing slice of this capacity growth is likely to be taken by domestic Chinese automakers that build their own vehicles outside Sino-foreign joint ventures. Although they now only represent about one-quarter of the market, with an installed production capacity of a mere 560,000 units to date, they are set to triple this by the end of the decade. Some industry reports suggest that 50% of sales in China will come from domestic production with domestic proprietary technology by 2010.
Rising Investments in India
Domestic and foreign automakers in India have strong capacity expansion plans. MUL, the leading manufacturer, is currently operating close to its peak capacity of slightly more than 500,000 passenger cars and light-duty utility vehicles per year. It is in the process of building a new manufacturing plant with a capacity of 100,000 cars per year, with scope to increase to 250,000. The new plant will start production by the end of 2006.
Hyundai Motor India Ltd., the market's No. 2 player, is in the process of doubling its production capacity to 600,000 units per year by 2007. Tata Motors, India's largest fully integrated automobile company, with a manufacturing capacity of 420,000 vehicles per year, has an Indian rupee (Re) 80 billion ($1.8 billion) capital expenditure plan over the next three years. This is aimed at improving the company's product portfolio in the domestic passenger and commercial-vehicle markets, including a microcar project.
Honda Siel Cars India Ltd., the fourth-largest player in India, also has plans to raise production capacity to almost 100,000 cars per year by 2010--doubling its current 50,000 units per year. Foreign automakers are also angling for a piece of the action. DaimlerChrysler's production facility in India, which was established in 1995, is assembling S-Class, E-Class, and C-Class models, and could be expanded if demand grows from the current modest level of 2,000 units in 2005. BMW AG (A+/Stable/A-1) is in the process of establishing an assembly plant at an investment of $23 million. This is expected to start assembly of 3-series and 5-series vehicles for sale in India in the first quarter of 2007. It will have a similar capacity to the existing DaimlerChrysler plant.
Japan's Toyota is planning to build a gearbox manufacturing plant in India to serve the Asian market, as well as develop a compact car for the Indian market. And Italy's Fiat SpA (BB-/Stable/B) resumed production of various models in January 2006 and will be sourcing components worth $10 million from India in 2006. The combined medium-term investment budget of foreign automakers in India is estimated at about $1.5 billion--a relatively modest figure compared with that in China, demonstrating that the Indian automotive market is a number of years behind the Chinese market.
Unlike China, however, India has started earlier to build a meaningful passenger-car export business, with about 160,000 units exported in 2004 (from less than 50,000 units in 2001). Hyundai Motor India is the country's biggest auto exporter.
Poor Quality Is a Problem in Russia
In Russia, foreign automakers have been following three strategies to establish themselves. First, through joint ventures with domestic partners, such as GM-AvtoVAZ or Avtoframos, which is joint venture between Renault S.A. (BBB+/Stable/A-2) and the Moscow city council. Second, by assembling under license at domestic producers' facilities (such as Hyundai at TagAZ, KIA Motors Corp. [BBB-/Stable/--] at IZH-Avto). Third, by increasingly setting up their own green-field assembly plants (Ford, Toyota). VW decided to enter the Russian market with a new production facility in 2006. Its goal is to increase its market share to 10% from currently 2% by 2011. A total annual production of 250,000 units is planned five years after plant opening.
The big stumbling block for foreign carmakers, however, is the low quality of locally produced components, which is preventing the establishment of full-scale production in Russia. At present, foreign brands assembled there are mostly made from imported components, so that foreign producers cannot fully benefit from a domestic cost advantage, although the recent reduction in import duty on car components will help. Competitive pressure on domestic carmakers is expected to increase further if local component producers fail to adjust quality in line with international requirements.
Mixed Profitability in the New Markets
In the three emerging auto markets, profitability is strongest among Indian automakers, aided by good production efficiency and financing profits. The industry-average profit margin before depreciation, interest, and tax has grown to about 12% from below 10% over the past six years. Indian market leader MUL posted the strongest growth in profitability, to 16.9% in fiscal 2005 from 9.9% in fiscal 2000.
Industry-wide profitability over the past two years has been relatively stable, highlighting the efficiency gains attained by the manufacturers, which have offset significant steel price increases. In 2005, the industry overall benefited from another year of strong GDP growth that resulted in higher per-capita income, low interest rates, and varied financing options. With India's government committed to infrastructure spending and economic growth likely to remain strong, the automobile industry is expected to be able to post further profitable growth in the medium term. In contrast, profitability in China has suffered from pressures of overcapacity and the fragmented market.
Vehicle prices in China, which used to be significantly higher than those in most other markets, have been falling rapidly since China's accession to the World Trade Organization (WTO) in 2001. Since then, car prices have sunk to levels in line with the world market, as a result of the nation's tariff cuts and rapidly growing competitive pressure. High material costs and lower--albeit improving--quality and availability of components, as well as higher production costs than the world average have contributed to declining levels of profitability. Labor costs, however, remain favorable, amounting to only 20%-25% of the world average.
In spite of ongoing shortfalls in production efficiency, automakers have started to increase exports from China. In 2003, they shipped fewer than 1,000 units, but this number rose to 10,000 units in 2004 and a remarkable 170,000 in 2005, surpassing the volume of imports for the first time, by 10,000 units. In terms of value, however, exports amounted to only $1.6 billion, which was much less than the $5.2 billion value of imports.
Despite these pressures, Chinese automakers are starting to make their mark on the international stage, heralded by their entrance to international auto shows, such as the Frankfurt Auto Show in September 2005 and the Detroit Auto Show in January 2006. Chery Automotive has made an agreement with a U.S. distributor, targeting sales of 250,000 units per year, mainly low-budget entry-level cars, in the U.S. by 2007. And Geely Automotive has announced plans to set up a production site in Eastern Europe in the next five years.
The first Chinese automaker to enter the European market is Nanjing Automobile Corp., through its takeover of a majority stake in U.K.-based MG Rover Group Ltd. (Both companies are unrated.) Furthermore, domestic Chinese automakers are planning exports into other emerging markets such as Russia, where the obvious advantage of Chinese brands--low price--is of greater importance than in mature markets. Geely's strategy, for example, is to focus on exports to the low-end markets of Russian Central East Asia, and Africa.
Nevertheless, quality concerns still present an impediment to widespread export growth to mature markets. Overall, while many of the published plans may appear ambitious, we expect that Chinese automakers will add to competitive pressures in the U.S. and European markets in the medium to longer term.
The profitability challenge for Russia's domestic automakers centers on the country's largely inefficient production plants and carmakers' current focus on low-budget cars, which command thin margins. These inefficiencies are partly offset by overall low production costs, allowing domestic producers to reach profitability levels comparable with global peers—although lower than expected for an emerging market.
Deals On Wheels: Customer Financing Grows
One factor that is supporting higher car sales in emerging markets is customer financing. This development is most advanced in India, where automotive financing is close to the global average of 70%, as opposed to just 15%-20% in China and Russia. India's auto finance market is dominated by banks and other financial institutions, which make up about 85% of the total market, but domestic automakers also aspire to expand their own finance companies. Tata Motors, for example, has announced plans to finance 40% of Tata-branded vehicles over the next few years, from 23% now, and plans to enter refinance, insurance, and fleet management. The increased focus on second-hand vehicle financing in India may also have a positive bearing on demand.
In China, the way was paved for domestic and foreign companies to engage in providing car loans to customers only in 2003, when the central government's Banking Regulatory Commission issued the Administrative Rules Governing Auto Financing Companies. Most foreign manufacturers have made preparations for car-finance businesses in the country and applied for, or received, a license. A number of expansion projects are also planned by commercial banks and captive finance companies in 2006.
Standard & Poor's Ratings Services believes that the growth potential for auto lending is significant, in line with the overall development of mainland China's financial markets. However, as in other developing markets, the lack of available credit-scoring data is an impediment for making auto loans and adds risk to consumer-finance activities.
Similar to China, consumers in Russia buy the majority of cars directly, without financing. However, we expect auto lending to expand in the medium term, in line with the development of banks operating in Russia's car market. Furthermore, the interest rates payable on car loans have declined in recent years.
Risks Ahead in the Emerging Markets
Foreign automakers face numerous regulations, risks, and restrictions in emerging markets. Since China joined the WTO in 2001, tariffs on vehicle and auto-part imports have been declining. Nevertheless, car imports have remained relatively stable in recent years, as more of the foreign manufacturers' efforts went into producing locally rather than boosting import activities.
A further risk factor associated with investing in China is the legal uncertainty, including the chance of intellectual property violation. Several examples illustrate how difficult it is to protect proprietary technology, design, and trademarks in this legal environment. Take Toyota, which went to court over the wrongful use of its logo, but eventually lost the case. Honda has also been involved in lawsuits against two domestic motorcycle companies over trademark violations.
The problem is even more pronounced for spare parts, the technology and design of which are harder to protect. VW, for example, is reported to have discovered that local suppliers copied parts used at SAIC's then affiliate Chery Automotive. A strategy that was popular among foreign auto manufacturers in the early days of investing in China--using old technology and offering models from the previous season to protect proprietary technology--is now considered impossible to sustain, as a result of increasing competitive pressures.
The regulatory environment in India is more accommodating to foreign entrants, and copyright protection -- based on the British legal system -- is stronger. There are no restrictions to setting up a car manufacturing plant, as 100% foreign ownership is permitted. India's new Auto Policy of 2002 led to a reduction of import duties on components and CKDs (completely-knocked down units) to 15% in 2005 from 30% in 2003, stimulating domestic production.
Furthermore, foreign direct investment was encouraged by the provision of tax incentives. In line with WTO regulations (of which India has been a member since 1995), import duties and excise duties on import vehicles--while remaining high in absolute terms--are being reduced gradually. Nevertheless, tariffs on second-hand cars remain particularly high at a combined more than 120%, to protect the country's domestic auto industry. In Russia, foreign automakers face inconsistent and unpredictable regulations, and a history of government interference in the market.
Domestic car production is very labor-intensive, and car manufacturers such as AvtoVAZ are often the largest employers in their region, so that their bankruptcy would mean a social crisis. At the same time, domestic cars cannot compete on equal terms with foreign cars due to their quality disadvantages. The government has been protective toward domestic producers by introducing import barriers, perpetually restructuring tax obligations, and to an extent being reluctant to let foreign producers establish local production.
The obvious benefits, however, to Russian consumers of the presence of foreign cars and foreign carmakers--which create significant investments in the regional economies, generate new jobs, and lead to increasing tax revenues--have driven the ongoing changes in the Russian automotive market. Nevertheless, there are warning signals that the situation might reverse. Moscow has been strengthening its control over various sectors of the Russian economy, and the automotive industry is the latest point of its interest.
The government gained effective control of AvtoVAZ in December 2005 and announced its plans to consolidate the other largest local producers under the United Automotive Co. These plans resemble the recent initiative to consolidate all Russian aircraft producers, which is not yet completed and the outcome of which is still unknown. The government is reportedly ready to spend $5 billion to develop new models to compete with foreign cars.
Will Eastern Automakers Go West In The Long Term?
Taking the long view, it is clear that the emerging auto markets of China and India are likely to offer high growth in a largely saturated global market. And although not as alluring as Asia's two burgeoning markets, Russia, too, is likely to remain attractive to the industry. While high volatility has plagued many emerging markets in the past, the conditions now in place in China and India, especially, will probably provide a level of stability.
The Indian market is in some respects mirroring the development of the Chinese market with a few years' time lag, but without the explosive growth seen in China in 2002 and 2003, when private car ownership began to flourish. The steadier pace of investment in India suggests that automakers might be trying to avoid the overcapacities that have appeared in China. We expect automakers to continue to tread more carefully in the Russian market.
As the new Eastern markets eventually consolidate, the strongest domestic players will be best placed not just to anchor their home market positions but also to put pressure on Western markets through exports and the establishment of production capacities, as indicated by Chinese automakers' plans to build plants in Eastern Europe in the next five years. Indeed, it may not be too long before the emerging Eastern automakers turn the tables and begin to look West.