Tuesday, December 07, 2010

Why importing used cars may be a bad idea

TEXT (December 07, 2010) : An interview with Hirofumi Nagao, MD and CEO of Pak Suzuki Motor Company
Limited. Speaking to BR Research Mr Nagao sheds light on the issues and challenges faced by the auto industry of
Pakistan. He talks about the progress and prospects of localisation in the industry, the often overlooked
disadvantages of allowing the import of used cars, the detrimental impact of a depreciating Pak rupee against the
yen, and the need for more conducive governmental policies for the auto industry.

BR Research: Your comment on auto industry's present conditions? Hirofumi Nagao: Presently, the auto industry is
going through a recovery phase after facing a major decline in sales of 47 percent in the year 2008-09. The industry
has shown a growth of 51 percent in the year 2009-10 producing about 141,654 units as compared to 99,307 units in
2008-09. However, the growth of 51 percent in 2009-10 is still far below the highs we have seen in 2006-07 when
204,212 units were produced.

Some of the factors that contributed to the slow down in the auto industry include a general slowdown in economic
environment resulting from rising interest rates, lower auto financing due to high mark-up rates, and a decline in
purchasing power of consumers due to high inflation. An increase in car prices due to an increase in the prices of raw
materials, utilities, cost of local and imported components, and, most important of all, depreciation of the Pak rupee
against all major foreign currencies.

BRR: What is the single biggest factor behind high car prices in Pakistan? HN: The main reason for increase in prices
is depreciation of the Pak rupee against major foreign currencies such as the US dollar, euro and the Japanese yen.
BRR: Given that economy is still in a fix and local manufacturers are suffering from poor margins, do you think it is
feasible for local manufacturers such as yourself to increase their localisation level through investments? What could
be a possible strategy to improve margins?

HN: At Pak Suzuki, localisation is a continuous endeavour which is evident by the highest localisation in Suzuki
products. But the impact of localisation is being washed away by the increase raw material prices, the price of
imported & local components, utilities and other factors resulting in a decline of profit margins.

However, localisation also requires some financial feasibility. The components which require high investment need
higher volumes. Therefore, it is imperative that the volumes should increase, and this requires some sort of a
stimulus package from the government in terms of special interest rates for auto financing or the reduction of duties
and taxes.

BRR: How exactly will the industry benefit from the government's stimulus package?

HN: You see the automobile industry has great potential for growth as the motorization level in Pakistan is still around
eight vehicles per 1,000 persons. So substantial room for growth exists. What is needed are favourable economic
conditions and government support, which can come in the form of special financing facility for the auto sector.

The auto industry has strong forward and backward linkages making it a job multiplier. With each person working in
the OEM plant, there are 10 persons working at vendors, dealers and suppliers, and 100 indirect supportive jobs are
created. Considering these factors, governments in other countries have provided due support to their auto
industries. It's no wonder that during the recent global recession, several countries including the US and the EU
countries provided support to their respective auto industries.
BRR: Commodity prices are not showing any signs of tapering off, whereas the local economy appears to remain
weak; if this situation prevails for next 2-3 years, do you think the industry would be able to endure weak margins?

HN: The auto industry like any other industry has to make profits for survival. Every year, huge investment is required
only to maintain operations. Pak Suzuki's capital expenditure for the last five years has been above Rs 1 billion per
year. It is difficult to forecast the future.

BRR: The local market is currently dominated by Japanese auto manufacturers. But are there any chances that some
other auto manufacturers from China, Korea and Thailand may enter into the market down the line. HN: There is no
restriction on any other manufacturer to enter the Pakistani market. In fact, new entrants will have privileges over
existing OEMs, such as being allowed to import 100 percent components at the CKD rate of normal duty (32.5%). On
the other hand, existing OEMs have to pay a 50 percent custom duty on parts manufactured locally, if imported.

The policy is unfair and is detrimental to the local vendor industry as there is no additional custom duty for import of
indigenised components. PSMC and PAMA have been requesting the concerned ministry of the government of
Pakistan to provide the same policy to the existing OEMs for introducing new models.

BRR: There have been some concerns about the recent yen movement. How likely is a 16-17 percent rise in the yen,
that we have seen since the start of 2010, to impact local manufacturers? Is the local industry in a position to further
absorb inflationary cost pressure?

HN: Local manufacturers are directly affected if the value of the yen rises because it increases the cost of imported
parts. Since Jun-2007, there has been a 113 percent deprecation in the Pak rupee against the yen. However, Pak
Suzuki has adopted a policy to pass on minimal impact of rupee depreciation to the final consumer and absorb the
remaining impact by lowering its profit margins, which is evident from our profit margins for the last two years.

BRR: In your opinion, what is the actual size of the spare-parts market. And, what percentage of that market is
captured by the undocumented sector such non-genuine parts, mis-declared and under-invoiced parts, etc? Has the
government adopted any method to curb smuggling?

HN: It is difficult to identify the actual size of the spare-parts market but it can be fairly estimated between Rs 30~40
billion. The major portion is captured by the undocumented sector. Government policies are there to curb smuggling
but they need effective implementation. BRR: What is your take on the Ministry of Industries' stance that supports
commercial import of used-cars to foster competition in local industry?

HN: To support the local auto industry, a complete ban on used cars import should be implemented jusr as the
government of India is doing. Import of used cars does not bring any investment nor does create employment, and no
technology transfer occurs. Besides, the process is not fully documented and while users have to deal with high
maintenance costs and pricey spare parts and limited after sales service without any warranty.

Also, foreign exchange per vehicle consumed in the import of used cars is much higher than the CKD operation,
resulting in an additional burden on already limited foreign exchange reserves.

So instead of allowing the import of used cars, the government should support the local auto industry firmly by
enhancing the confidence of both OEMs and vendors, as this industry, with a turnover of more than Rs 103 billion, is
saving foreign exchange to the tune of $2.4 billion annually through local operations.

Nearly 2000 tier-I and tier-II auto parts manufacturers are linked with OEMs, providing employment to 1.4 million
people through forward and backward linkages including direct/indirect employment of 192,000. BRR: By how much
do you expect the local auto market to grow in the next few years? Also, which segment do you think will grow faster?
What is PSMC's auto sales projection for the next five years?

HN: It is very difficult to forecast about market growth in next few years due to economic instability and the absence
of consistent long-term auto policy. But, as an optimistic estimate, if the industry grows by 12 percent every year, then
after five years the cars market (including vans) could increase upto 218,530 from the current 124,000. Higher growth
is expected in the above-1300cc segment. Pak Suzuki will strive to maintain its 50% market share.

BRR: In your opinion how long will it take the industry to achieve a level of localisation of nearly 90 percent?
Localisation will increase if sales volume increases. The policies should be made such that there is growth in the auto
industry volumes. If volumes grow, localisation will take place automatically.

BRR: How will the RGST affect the auto industry? What are your estimates about the likely price hike after the RGST
for both highly localised and less localised carmakers? Being a fully documented industry, prices of cars will not
increase after implementation of RGST, as the rate of sales tax will decrease from 17 percent currently to 15 percent.
However, the decrease in sales tax will be offset by the increase in Special Excise Duty from 1 percent to 2 percent.