Russia has potential, but there are problems beyond the current crisis
Global automakers are in a bind in Russia as the conflict in Ukraine -- made worse by the shooting down of a Malaysian airliner reportedly by pro-Russian separatists -- risks destabilizing the region.
For General Motors, Ford, Volkswagen, Renault-Nissan and other carmakers, the giant country is an emerging market with huge strategic significance. But the risks are there, too, and they also are enormous.
Companies are bracing for a brutal second-half recession in Russia's car market, Europe's second largest, in some cases scaling back their operations as sanctions are likely to land a knockout blow to investment and consumer demand in a country already reeling from a slump in the economy.
Yet despite the turmoil and uncertainty, automakers say they remain committed.
Ford CFO Bob Shanks: "Russia is potentially the largest market in Europe."
"Russia is potentially the largest market in Europe," said Bob Shanks, Ford's CFO, as the company announced its quarterly earnings last week.
Last year, Volkswagen CEO Martin Winterkorn described Russia as its "No. 1 strategic growth market in Europe," and there is nothing to suggest that might change over the long term. But automakers have begun to slash their estimates for 2014 volumes radically following a ter-rible June.
Prospects have darkened considerably now that geopolitical tensions in the region add to sluggish economic growth, a poor network of roads and highways, neo-mercantilist trade policies and an overreliance on revenue from oil and gas exports.
Juergen Reers of consultancy firm Roland Berger, which authored a sobering study on the health of Russia's auto industry, said automakers have no choice but to remain strategically committed to Russia because of its potential to eclipse Germany one day as Europe's largest car market.
But investing further is also dangerous given the risks.
"Growth has come to a dead end, the market is in a recession now that consumers and businesses are reluctant to invest, and that will influence both sales and production in Russia," Reers said. The Ukraine crisis "will only strengthen existing negative trends."
Experts say Russia possesses the best potential for profitable growth outside China because of its low level of vehicle penetration and greater share of large, higher-margin cars than India or Brazil. But they also point out that deep-seated problems were depressing demand in the country before Russia's land grab in March.
Sales were already on the decline last year, hurt partly by cuts in infrastructure spending but mainly by a fee placed on imported cars for their recycling that together with a depreciation in the ruble kept a lid on demand. It was effectively a nontariff barrier, and Russia was forced to extend the poorly conceived measure to locally built cars at the start of this year to settle a trade spat, further hampering sales.
As a result, AEB, Russia's industry body, had already revised its estimate for a market contraction days before the Malaysian Airlines catastrophe, forecasting that volumes would shrink this year 12 percent to just 2.45 million vehicles vs. a previously seen fall of just less than 2 percent.
"The market weakness has not reached its bottom yet," Joerg Schreiber, chairman of the AEB Automobile Manufacturers Committee, warned at the time, after the slump accelerated to a 17 percent drop for June.
The poor outlook prompted Ford Motor Co. last week to book a $329 million charge to impair the value of its Russian joint venture with local partner Sollers, where 17 percent of its work force was let go in June and production in its St. Petersburg plant was reduced to just one shift.
While Ford said it would not sound the retreat from Russia given the country's size and importance, it announced further impending changes to its operations there, explaining that it was "working with its partner in Ford Sollers to develop actions to improve its business outlook."
Russia's car market problems couldn't have come at a more inopportune time. Ford Sollers is scheduled to bring a third manufacturing site onstream in Naberezhnye Chelny in Tatarstan in September, even as 950 jobs in its other two plants were cut.
Ford's Shanks said that regardless of the problems, "we're continuing our participation in that market. We've got a number of launches planned there."
GM production cut
Russia also is critical to GM's loss-making Opel unit. In what was seen as a victory for Opel, GM agreed to hand responsibility for the Russian market to the European carmaker at the start of this year.
Russia remains Opel's one and only growth market, but the brand has been unable to capitalize on its newfound influence.
First-half sales of Opel cars slid 15 percent, twice as fast as the overall decline.
GM CFO Chuck Stevens said the automaker has reduced production at its plant in St. Petersburg 20 to 25 percent this year.
The tragic loss of nearly 300 lives aboard flight MH17, shot down over eastern Ukraine amid a domestic conflict involving ethnic Russian separatists, may also discourage companies from expanding their current investment budget in Russia, now that Western powers are imposing further punitive measures aimed at punishing Moscow for its disputed annexation of Ukraine's Crimean peninsula.
The UK bank Barclays believes, for example, that Russia could now lose out to other countries should investors decide political risks are too high and shift their funds elsewhere after the U.S. government decided to bar several major Russian corporate borrowers, including oil giant Rosneft, from raising capital on U.S. debt markets.
"The money that could leave Russia may find its way to other emerging market destinations," the bank wrote in a July 17 research report.
In a surprise blow to Russia's foreign direct investment, executives at Daimler confirmed last week that the German auto group decided against raising its stake in local commercial truck maker Kamaz. Mercedes-Benz's parent added in its second-quarter report that it still saw "no signs of an end to the market contraction in Russia" triggered by the Ukraine crisis.
By comparison, Volkswagen is sticking to plans to invest another $1.62 billion in its Russian operations on top of the roughly $1.75 billion already spent in local production and new models for Russia over the past eight years, but it, too, is spooked.
"We are monitoring the current developments in Russia and the Ukraine very closely," VW said in a statement to Automotive News. "The Volkswagen group hopes for a stabilization in the situation in the Ukraine and a peaceful solution of the conflict."
To help it raise annual sales to over a half million cars and garner at least 14 percent of the market by 2018 -- which would be up from about 300,000 and nearly 11 percent last year -- VW will begin assembling 1.6-liter gasoline engines near its Kaluga plant starting in 2015.
Bo Andersson, CEO of AvtoVAZ: "Long term car market demand is continuously strong, [there are] still only 274 cars per 1,000 people."
Need to rethink
Roland Berger's consultants argue strongly, however, that companies need to rethink their investment plans, since the industry's structural problems in the country will only be aggravated by Russia's entry into the World Trade Organization.
Once government incentives to manufacture locally expire in 2018 as part of its admission into the club, carmakers will find themselves stuck with high logistics costs, low productivity and other problems inherent to Russia that have not been solved.
The consultants believe there is a risk that declining automotive production volumes will lead to the exit of certain market participants and the downsizing or closure of several assembly plants, all of which will eventually culminate in a creeping deindustrialization.
"Low volumes per platform and per model result in scale disadvantages, and there are no cost benefits from a labor force perspective, so some of these smaller plants will lose their right to exist if the same car is built in Europe," Reers said.
He calls for renegotiating localization obligations, linking them to tangible long-term support commitments and reducing the number of locally produced models -- or if need be shrinking the manufacturing footprint entirely.
For now at least one Russian carmaker is taking the slump in stride. Bo Andersson, CEO of AvtoVAZ, maker of Lada cars, said last week he remains "rather optimistic."
"Long term car market demand is continuously strong, [there are] still only 274 cars per 1,000 people," he wrote an e-mail.
"Since we do not interfere with political matters, we don't comment on sanctions and issues linked to Ukraine. We try to do the business as usual."
You can reach Christiaan Hetzner at email@example.com.