Russia to launch out lumberingly to the rebuilding and modernization of automotive industry by earnestly promoting foreign investments
Background and aim of a concept for the development of Russia's automotive industry in the period until 2010

Russian Prime Minister Mikhail Kasyanov reportedly signed a concept on July 18 for the development of Russia's automotive industry in the period until 2010. It would be submitted this fall to the State Duma to adopt it. The concept, representing the Russian government's intention, includes the retainment of import customs duties on new and old cars, the consideration to lower the customs duties on equipments and development of components production with special attention paid to attracting foreign investors to re-build and modernize the automotive industry in Russia.

In a post Cold War era, overseas major carmakers were not active in investing in Russia. Therefore Russia's cars and component manufacturers, which differ from the ones in Central Europe, have not yet been reformed and modernized. The local component makers have been still integrated vertically under the local carmakers.

But Ford and GM commenced to invest and launched to produce Focus and Niva in earnest this year. Some European and American component makers also have started operation. Thus, signs of change began to appear. Economic state that was once depressed by financial crisis in 1998 has favorably recovered and been expanding with the devaluation of rubles, income increasing in foreign currency by soaring oil and gas price and political stability induced by President Putin. As a huge investment by BP shows, foreign investors' credibility has also recovered.

Under the situation, Russian government aims to form the basis of the restructuring and development of Russia's automotive industry with the help of foreign investments. Klevanov, Minister of Industry, Science and Technology, released on July 2002 that they are working up a law bill dealing with special economic zones, as a practical measure for the aim.

■The concept until 2010 to set up difficult targets to reach with a status quo

[Concept for the development of Russia's automotive industry in the period until 2010] was approved basically on March 21, 2002, dated back 4 months from the signing date by Kasyanov. According to a high official, the draft was submitted to the government three times and sent back for polishing each time. Kasyanov, who graduated from Vehicles and Roads University of Moscow in 1983, rewrote the final version personally and put a proposal into the concept concerning a single flat import duty rate, unified ecological requirements including a time table for the change-over to the production engines meeting with European standards.

In defiance of disputes over the protectionism of the concept in the government, the concept indicates to lower import customs duties for all foreign made cars, after it keeps them for the following 7 years. Besides It emphasizes that domestic production in the future should make use of components made in other countries to improve the quality of the end product and that the building of engines, brake systems, steering controls, electronics and exhaust treatments should be reinforced by attracting foreign investors. It also shows a timetable for the changeover to the production of engines meeting with European standards that would be regarded difficult for the current technical and development capability of Russia's automotive companies to cope with. Which means to hasten the local makers to carry out a drastic reform.

Requirements applied for foreign investors in order to be granted investment incentives are so rigorous. Considering the current situation that only customs duties exemption for 7 years are applied for investors - based on Executive order by former President Yeltsin - and that there is no special agency for promoting foreign investment, the concept, stressing the promotion of foreign investment, goes beyond an industrial policy in the past and is undoubtedly a bill with a strong political leadership.

■Digest: Concept for the development of Russia's automotive industry in the period until 2010

■An example of Russia's cars production and sales forecast

(1,000 units)

	2000 actual	2001 actual	2002	2003	2004	2005	2010
Production	969	1,022	1,058	1,130	1,210	1,300	1,900
Sales	1,089	1,188	1,350	1,350	1,406	1,500	2,200

Source: Nauchno-Issledovatelskiy Avtomobilny i Avtomotorny Institut

■25% import customs duties for all foreign made cars to retain in following 7 years

The import customs duties are the same on new and old cars and lowered from 30% to 25% in 2000. The concept specifies 25% would be valid for the following 7 years and suggests it to be lowered after then.

In Russia, when the average customs duties rate is 10%, the customs level of 25% is exceptionally high, the same as the duties of chickens, sugars and spirits to protect the domestic industries from the imports. Therefore, it is assumed that Russia has to admit further customs reduction at a certain transitional period to succeed in WTO accession whose negotiation is going on with Russia's intention. In the case of China, which joined in 2002, the customs duties of 70 to 80% before the accession would have to lower gradually to 43.8 to 50.7% in 2002 and 25% in 2006 in a 5 years' transitional period.

The concept means to show 7 years as the preparing period to rebuild Russia's automotive industry and reinforce the competitiveness. Meanwhile, under the current situation, imported old cars whose price is much closer to cars made in Russia have threatened Russia's automotive industry.

■Cars sales by brand in Russia

(Units)

	1999	2000	2001
Russian brands	1,001,016	1,041,289	1,108,379
Lada	627,578	699,323	776,732
Izhmash	4,224	12,357	45,388
GAZ	229,969	193,108	150,000
Others	139,245	136,501	136,259
Import brands	42,966	47,643	79,232
Total	1,043,982	1,088,932	1,187,611

Source: Avto-Revue, AO Avtoselkhozmash, Ernst & Young CIS
(Note)	1.	Includes utility vehicle. Lada is made by AvtoVAZ. Izhmash is under control of AvtoVAZ.

■Russia's car market in 2000

■Average retail sale price in 2001

■Impact of 1998 Crisis on Car Prices

(% of Market by Model Price)   1998 1999 Below $ 5,000 Below $10,000 Below $15,000 Above $15,000 3% 68% 83% 17% 85% 97% 98% 2% Source: General Motors Corp.

'In Russia's cars market, demand for cars of less than US$5,000 exploded from 3% in 1998 to 85% in 1999 while demand for cars above $10,000 almost disappeared'. Cited from [GM to launch Niva project with export promise and 90% Russian content, (MarkLines report No.75, June 2002)]

■Customs duties for imported old cars that compete with cars made in Russia, to shelve to lower

New cars' sale in Russia was 1,090,000 units in 2000 and 1,190,000 units in 2001, which included 50,000 units and 80,000 units from abroad respectively. Besides, a considerable number of old cars were assumably imported.

There are no official statistics on illegal imports of old cars, which are estimated huge. Though, based on Express Objava, Russia's newspaper, out of 1,160,000 passengers cars sold in 2000, 10% was imported new cars and 9% was imported old cars. And Volin, the deputy Head of the governmental administration, also noted in January 2002 that 600,000 units out of 680,000 units imported in 2001 were old cars.

Russia's cars output, which was 970,000 units in 2000 and 1,020,000 units in 2001, has been stagnating in the range of 800,000 and 1,000,000 units since the collapse of USSR in 1991. It is also one of the reasons why Russia has increased the imported old car market.

Given from the above, the customs duties rates for old cars have been paid attention. Domestic carmakers and official import traders of new cars have strongly requested to raise the customs duties for cars aged more than 4 years, which Russia officially regards as old ones regardless of diameter, to reduce the old cars imports, making out an environmental contamination induced by those cars as an official reason to the government.

But the increasing of the import customs for old cars was shelved, considering the people's demand for a reasonable price and good quality cars and the possibility to increase smuggling and reduce the official imports even if the import duties are increased. Instead of that, as a measure to restrain the old cars imports to protect the environment, the concept includes a higher insurance premium for the cars more than 7 years old to make them disadvantageous to keep and use.

■Definition of Customs value on imported cars in Russia

■GM and Ford projects to be expected to attract investment by foreign component makers

It seems difficult that current Russia's automotive industry can create its competitiveness by itself to beat imported old cars, 600,000 units of which were imported in 2001. For example, GAZ, the second largest cars manufacturer in Russia, that developed GAZ-3111 as the main model, succeeded GAZ-3102 with components of foreign component makers such as lights from Hella, seats from Lear, engines from Styer, Venture and Haden to improve the car's quality. As a result, expected retail sale price had to rise to US$ 16,000 the same price level as that of the imported middle class, and GAZ decided to exclude it from their mass-production models. It means Russia's component manufacturers are still scarce of the developing and manufacturing capability for high quality components.

Then, investment projects by GM and Ford become the center of public attention. Russia expects that through promoting their projects, more attention shall be paid to investment in Russia.

GM needs to achieve in a new venture with AvtoVAZ to raise the Russian value in the products, SUV Niva, from 10% to 50% in the 5th year from production launch, to be granted the investment incentive to full exemption from import customs duty of components. Besides the venture has to provide cars whose price would be around 20% less than that of the competing imported cars, to arouse the interests of Russians that does not rely on the goods produced domestically, not only for promoting exports of Niva. So, achievements in the local sourcing and the incentives are critical issues to the project's success.

■New venture by GM and AvtoVAZ in Russia

On the other hand, Ford also started to assemble Focus by CKD at the end of 2001 at Vsevolozhsk, 15km from St Petersburug. The output in 2002 targets 5,000 units. Also it is planned to increase to 25,000 units annually although the capacity is 100,000 units. Similarly to GM, Ford has endeavored to raise the Russian value. Unlike GM, Ford, that has brought their own model, shall have more energy to find the local suppliers, though they released to find 5 local suppliers and to keep on track. It would be essential for Ford, whose plant can expand the capacity to 100,000 units annually, to optimize the assets in order to expand the local sourcing by inviting foreign component manufacturers.

■Ford's venture in Russia

■New movement to form group by local components makers while it is so difficult to make alliance with foreign companies

Russia has over 2,000 suppliers ranging from behemoths to "garages". Auto components are: core output for 200; important output for 400 specialized in another field; and peripheral output for the other 1,400.

Most component makers are under a serious and confused situation, because local car manufacturers have been facing serious management difficulties when most parts makers are controlled directly or indirectly, regardless of their size, by a carmaker. In fact, Russia's automotive industry is so vertically integrated that an automaker is said to procure 80% of components from inside of the company or the group.

For example, the largest 2 manufacturers, AvtoVAZ and GAZ, have such a huge accumulated loss that they cannot launch development and production on a new model. The main culprits were barter trades by the managements in the latter half of the 1990s to line their own pockets. In case of GAZ, 80% of sales in 2000 was from the barter trade. Car manufacturers paid with cars for components whose price was 20% higher than the market price.

AvtoVAZ made profit for the first time in 2001 since its reorganization to a join-stock company in 1993. It was 2.1 billion Rubles. Though the accumulated loss is over 10 billion Rubles and it impedes to contrive to raise funds for a new cars production. They have already reached their capacity limit and then it is difficult to improve the financial situation by increasing the output and sales, which fact makes AvtoVAZ to be aggressive to make alliance with foreign companies.

Sibirsky Alyuminiy, that acquired GAZ in 2000, has been restructuring GAZ by the separation of the social infrastructures to surrender to municipalities concerned, by the elimination of the barter trades and selling cars for cash before delivery. It reduced the sales but improved the financial condition by reducing the annual loss from 4.6 billion Rubles in 2000 to 100 million Rubles in 2001. But the outlook for the huge debt repayment is still in vague including an overdue US$ 65 million loans from EBRD in 1998.

The local component manufacturers are under difficult situation in finding the way to survival. As global manufacturers of autos and parts now insist on their suppliers meeting ISO9000 and other standards like QS9000 and VDA6.1, almost all of Russia's components makers are categorically excluded from international opportunities because they lack the certificates.

Even when Russian suppliers want to improve by inviting foreign investment, and they find interested partners, deals rarely materialize because the sides struggle to agree upon each party's share of management and ownership. Meanwhile, Barely 30 has an ISO9000 certificate. Though more may claim fraudulently to have this credential, as the black market has emerged in Russia for forging this paper.

Russian suppliers are reluctant to sell the controlling stake in their operations to foreign partners that may slash jobs because the labor productivity is one-thirtieth of the West. Plus automakers that patronize these suppliers may be wary too - because they do not want to relinquish leverage over their parts makers.

■Part makers granted ISO9000 in Russia

Under such situation, a new movement, that does not make alliance with foreign companies, has appeared to form an industrial group by local component companies and to utilize all their management resources to be more competitive for foreign companies. The most typical and dynamic group is led by SOK which is expanding its business through acquiring local part manufacturers one after another, making use of a strong relationship with AvtoVAZ.

■Summery of SOK (Samara Window Co., Ltd.) in Russia

■Major component manufacturers in SOK group

■Foreign component manufacturers to be successful with a various solutions

Russia has many hurdles against foreign investment. But some foreign companies could succeed in their business in Russia, employing means suited to the occasion, not insisting on investment.

Lear Corp, a US maker of car interiors, took over GAZ's in-house seat production in 1998, starting by renting the labor and space. This approach gave Lear access to large production volumes (over 200,000 units a year) without big initial investment. Now the US Company owns the production site, and it employs the workers. Revenue has varied ($20.66 million in 1998, $33.41 million in 1999, $14.49 million in 2000) with GAZ's fate, but Lear is in a strong position to support new projects of domestic and foreign producers in Russia, and it recently began talks with AvtoVAZ about providing seat components.

US supplier TRW Inc works closely with Russian parts makers without taking equity in them. Instead, it has installed equipment and technology (still owned by TRW) at Russian factories that produce parts for export. TRW has contracted OAO Avtoelektroarmatura (Avar) in Pskov to make roughly one third of all switches needed by VW group, and OAO Avtoagregat in Kineshma delivers brake and clutch cylinders to TRW.

■Foreign suppliers in Russia

Suppliers also have invested successfully in Russian partners. Belgian glassmaker Glaverbel SA, owned by Asahi Glass Co of Japan, has a controlling stake in OAO Borsky Stekolny Zavod (Bor), supplier of roughly two-thirds of all glass used by car factories in Russia. Glaverbel has lightened its obligations by sharing Bor's capital requirements with two financial institutions [European Bank for Reconstruction and Development (EBRD) and World Bank's International Finance Corp (IFC)]. The venture has been prospering (sales grew from 67.7 million euro in 1999 to 77.2 million euro in 2000, while net profit increased from 11.4 million euro in 1999 to 15.3 million euro in 2000), and Bor is receiving additional loans from EBRD and IFC to continue modernizing.

EBRD and IFC have made the development of Russia's auto industry a priority, each expecting its activities here to grow, following the start of production by Ford and GM. Recently, EBRD said it would invest in Intercos-IV (a producer of dies and molds near St Petersburg) and a new tire plant in Davydovo of Michelin et Cie of France.

Given the staggering volumes of used vehicles entering Russia every year, demand for foreign replacement parts is high, offering economic manufacturing volume to suppliers. This idea drives investment plans of tire-makers Continental AG of Germany and Michelin. Each hopes to supply domestic and foreign plants in Russia, but both initially will focus on the market for replacement tires, where profits are higher too.