AUTOMOBILE INDUSTRY ANALYSIS OF PAKISTANI INDUSTRIES

SUBMITTED TO DR. SALMAN SHAIKH SUBMITTED BY ADEEL AHMED

BISMA YUSUFZAI MUHAMMAD IBAD DESMUKH

MUSAID RAHEEL SAMITA KHOJA

JUNE 16, 2014

TABLE OF CONTENTS Introduction 2

Production and Supply Chain 5

SWOT and 5 Forces Analysis 10 Financial Analysis 13

Problems and Solutions 15

Comparison with other countries 29

Introduction Pakistan’s automobile industry made its humble beginnings in the year 1953 under the umbrella of National Motors Limited established in Karachi. Assembly of Bed ford trucks were the first output of this sector and with the passage of time buses, light trucks and cars were added to the portfolio. Later on, in the mid 1980s, Suzuki started the assembly of FX 800cc with a target market of the middle class in mind. In 1992, Khyber and Margalla were introduced which were a bit higher class (1000 and 1300 cc respectively). Suzuki has been the market leader since that time. The deregulation policies of 1990’s then opened doors for foreign manufacturers to enter the local scene and to this date they continue to reap returns from a lucrative market. Presently 3 major players dominate the market which are PakSuzuki, Indus Motors and Honda Atlas Motors. PakSuzuki has an almost complete monopoly in the small car segment as it faces almost no competition other than the single odd now discontinued Daihatsu Cuore produced by Indus Motors. In the Subcompact Sedan segment Toyota Corolla, Honda Civic and Honda City,are currently the only cars in production. There are still no locally made SUV, Mid or Full sized sedans available, except the Toyota Fortuner which is assembled in Pakistan. The automobile sector can be categorized into 6 major segments which are cars & light commercial vehicles (LVC’s), two and three wheelers, tractors, trucks and buses, Accessories and part manufacturers and Vendor Industry. In assessing the current scenario of the sector there are 3,200 units of automotive industry with the investment of Rs92 billion, with annual capacity of 1.8 million motorcycles and 200,000 vehicles. The magnitude of this industry can further be judged by its contribution to the national exchequer which is nearly 50 billion which is roughly 3% of the GDP. The sector provides employment to 2 million people and plays a pivotal role in sustaining a blossoming vendor industry. However with all its glory there are daunting challenges which are undermining the growth of this giant sector. During the first six months of 2013, almost 25,000 used vehicles were imported, amounting to 25 per cent of the total market demand for automobiles in the country and causing an annual loss of sales revenue worth Rs20 billion to the parts-manufacturing industry. The spare parts industry having a complementary relationship with the automobile sector is also feeling the pinch as the market for parts has shrunk by 30%. The government had revised its import strategy which now has cut the period of imported cars from 5 years to 3 years used cars. As a result imported vehicles will lose their charm and local assembled cars will regain their market.

Trend According to the Pakistan Automotives Report, the fiscal year 2008 witnessed a fall of 6.2% in total vehicle sales. The downward trend continued into the fiscal year 2009, with sales down by a huge 48% between July and December 2008. Compared to those of November, sales of December were down by 55%. However, the situation was not the same in 2002. In that year, the industry had gotten a huge boost, with an increase in the production and sales of locally assembled cars by 42% and 21%, respectively. The auto industry made up 2.8% of the total GDP in 2007 - and this figure was expected to go up 5.6% in the next 5 years. Total sale of automobiles amounted to Rs. 214 billion in the fiscal year 2006-2007. First 9 months of fiscal 2010-2011 automobile production rose by 14.6 percent.

Production cycle and Supply Chain The three major players in the automotive industry of Pakistan all assemble vehicles instead of manufacturing them. Auto parts are imported from various regions and some of them are also produced locally. Revo by Adam Motors was the only locally manufactured car which was made from scratch within the country, but production was discontinued due to extremely low sales and the inability to capture the market and enjoy economies of scale. Here is the supply chain process of an automobile: Raw Materials: This includes rubber, glass, steel, plastic, aluminium. The cost of raw materials has increased significantly over the last few years due to the rise in price of oil and natural rubber. Light weight materials are used to lessen the weight of the automobiles. Parts: Parts like windshield, tires and airbags are added. Parts are mostly imported from Thailand, Korea, Japan and Indonesia. These parts are shipped by sea. Assembly: This is the stage where the parts etc are combined to form the automobile. Companies try to cut costs at this stage through JIT, minimizing waste etc. Marketing: Marketing strategies are formed and advertising is done. Distribution and Sales: Pakistan has many showrooms through which automobiles are distributed to customers. The assemblers source parts from a variety of sources. Multi sourced parts (MSP) are imported from Thailand, Indonesia or Malaysia. High tech parts are usually imported from Japan (JSP). Pak Suzuki imports all the parts from Japan only while Toyota and Honda source them from various places. Usually the CKD (completely knocked down) is imported

from Thailand and other parts are sourced from Malaysia and Indonesia. Locally, they have a bunch of tier 1 and tier 2 suppliers spread all over Pakistan. These suppliers are guided and closely supervised by the assemblers for any parts that they require to maintain quality and standards.

Regulation in the sector A number of regulations govern the automobile industry in Pakistan. These include both the domestic legislation as well as international conventions which Pakistan is willing to comply with. Some of these are : General Agreement on Tariffs and Trade (GATT) : This lasted until 1993, when it was replaced by the World Trade Organization ( WTO ). Its purpose was to eliminate barriers to trade and facilitate reduction of tariffs. Trade-Related Investment Measures (TRIMs) : This was designed to encourage foreign direct investment in a country. Its purpose was to initiate trading agreements between countries and discouraged the idea of a closed economy. The automobile sector of Pakistan today operates within the rubric of several policies: The Auto Industry Development Program (AIDP); the Tariff Based Scheme (TBS) which ensures compliance to the WTO-TRIMs; Pakistan standards governing the sector and implemented through the Pakistan Standard Quality Control Authority (PSQCA); National Environmental Quality Standards (NEQS) which governs vehicular exhaust emissions. Since 1987, policies were formulated to place this industry on the path of ‘indigenisation’ or localization. It was believed that once complete indigenisation is achieved, prices will come down automatically. For this purpose, the import of vehicles remained banned till 2000 under the trade regime. However, import of used and reconditioned vehicles was liberalized under gift, personal baggage schemes and transfer of residence (TR). TR scheme initially allowed the

import of cars without any age limit on them. However, in 2006, the import of cars under the scheme was first restricted to three and subsequently to five years, making the policy more restrictive. On 1st July 2006, to comply with WTO rule, the Deletion Program for the automotive industry was replaced by the Tariff Based Scheme. During 2007-12, tariff on 800cc and 800cc-1000cc has increased from 55 per cent to 57 per cent and 65 per cent to 68 per cent respectively. However, 1,000cc-1,500cc is the only category in which Effective Rate of Protection fell from 73 per cent to 68 per cent over the same time period. AIDP- I : First Auto Industry Development Program (AIDP) 2008-12 outlined several conditions for new entrants including a minimum production levels achieved by the firms in cars, trucks, buses and agriculture tractors, a clear intent to produce parts locally, and proof of land ownership. These policy developments suggest that the overall thrust of the framework is still on indigenisation while offering protection to existing local manufacturers. Additionally, the restrictions on new entrants coupled with an increasing level of tariffs reduce the level of competition in the industry with the cost being borne by the consumers. Automobile industry with present manifestation is not viable. This is because there is a lack of domestic and foreign competition in the industry. In order to liberalize the automobile sector and to provide equal opportunity to existing and new entrants, new principles should be proposed which would serve as building blocks of a new automobile policy. The consultations on the development of AIDP commenced from the 8th March, 2006 Workshop at Islamabad by clearly defining the objectives. This was the time when the industry was switching over from the deletion program to a competitive tariff based system. It was expected that this transition could affect the rapid and sustainable growth of the automobile sector, which further demanded a need for a comprehensive development program with pre-announced tariffs in order to provide a predictable and stable environment. Government had approved a 5 year tariff plan for the auto sector to ensure a stable and predictable environment and to facilitate investment. Government focused on facilitating the

industry through development of infrastructure, human resource development, technology acquisitions, investment in productive assets, cluster development and development of standards on safety, quality and environment through a well-structured and deliberate approach. The cornerstone of approach remains close consultation and ensuring stakeholders participation in implementation and assessment of policy. AIDP aimed to achieve a critical mass of production, double the contribution of auto industry to GDP from the existing 2.8%, by the year 2011-12 with high focus on investment, technology up gradation, increasing its exports to US$ 650 million, enhancement in jobs alongside the development of critical components to further increase the competitiveness of domestically produced vehicles. AIDP-II According to news sources, the government was supposed to announce AIDP-II by year end 2013. The AIDP highlights the duty structure and the policies under which the industry would operate. AIDP-1 was launched in 2007 for five years, expiring in 2012. The reasons for the delay in the announcement of the new policy can be attributed to the transfer of democratic power in the country. However the current government seems willing to promote the industry hence the formulation of the policy is under process. According to a research done at BMA capital, the following are amongst the major proposals presented to the committee which are likely to have a favorable impact on the automobile industry: 1) Decreasing duty on CKD One proposal under consideration is to bring down the CKD import duty by 5 %. This would help in decreasing the costs of production for local manufacturers as well as prices of locally assembled cars. Consequently, aggregate demand would increase due to the increasing purchasing power of buyers. The decrease in duty could significantly improve industry’s volume as the buyers would be able to buy cars at more affordable prices. 2) Increase in age limit of imported used cars To recall, the used car import age limit was changed from 3 to 5 years in Jul12 which remained in effect till Dec12. This increase of age limit had an adverse impact on the industry’s volumes

that dropped from 81,935 units to 57,540 units (down 30%YoY) in 2HCY12. The re-enactment of the following could have similar results for the industry in the future. That said, it is believe the government will have issues in bringing out any such proposal given its detrimental effect on the local industry and amount of foreign exchange outflow. The premise of the auto policy is to grow the industry, conversely such a policy would destroy the local manufacturers and hence, the chance of major investments and growth in the sector. 3) Tax incentives to new entrants for indigenous manufacturing Another incentive under proposal is to provide new entrants with tax incentives to promote investments in the Pakistan auto industry. The kind of incentives offered could be duty free imports of CKD kits, Corporate Tax reduction, Advance Tax exemption for a period of 5-7 years. The reason for these suggestions is to introduce new entrants in the market in order to encourage competition as well as promote foreign investment in the country. These incentives would assist the entrant to break into the market, where the manufacturers have long standing presence and brand image.

SWOT Analysis Strengths: Increasing Demand for Cars: In Pakistan context there are 19 cars in 1,000 persons, on average, which is one of the lowest in the emerging economies. On the contrary, rising per capita income is slowly increasing the demand for cars. These facts reflect the potential for growth in this sector in the years to come. Resale of Local Assembled Cars: Resale of locally assembled cars is better due to availability of spare parts and after sales services and warranty e.g. Suzuki, Honda, Toyota have facilitated in the gradual growth in this industry.. Used imported cars have been selling below cost at the showrooms but consumers do not prefer them because of their low re-sale value and problems in parts availability. Quality of local cars:

Initially when the import of cars was liberalized, the quality of local assembled cars was substandard which led the people of high income level in buying imported cars and the sales of the local assembled cars fell. Therefore, the local assemblers started enhancing the quality of their vehicles and we can safely say that the quality of local cars is becoming the strength of the auto industry. OEM: The local OEM of Pakistan is well equipped with enough advance technology and skilled labor to produce parts according to the desired quality of any foreign company CNG kit: The advantage of buying local assembled cars is that they come with factory fitted CNG kits at the times when the prices of fuel rising at higher pace internationally. Mechanics: The market for local assembled car mechanics is easily available and much cheaper so the buyer should not be concerned about any problem that can occur in the long term for local cars. However, the availability for imported cars still remains an issue for the owners Weakness: Input Cost: Owing to the increasing level of inflation year by year, input costs are rising and it is becoming harder to produce at lower cost. Increasing cost of energy and its unreliable and inconsistent supply also contributes to the cost of manufacturing and wastage of resources Protection level: Before the TBS was introduced, the auto industry was well protected by the government but now as the import of CKD and CBU is liberalized the protection level to industry by government is decreased. Lack of skilled manpower for modern machinery: In Pakistan conventional machines are not able to meet the precision manufacturing and the available labor is not familiar with modern technology.

Scarcity of raw material especially steel: Steel and Iron are major raw materials in the production of automobiles. With the recent increase in their world prices, local manufacturers are having trouble in coping up with rising costs production coupled with scarcity of resources in the country. Opportunities: Introduce a Nano-like car: Pakistani manufacturers should make use of the opportunity and create a midrange automobile just like India Tata’s Nano. This would serve the purpose of an affordable car as many people in Pakistan cannot afford to buy a car for themselves as the starting price is at least Rs600000. Foreign Investment and setup production facilities: China National Heavy Duty Truck Corporation (CNHDTC), one of the largest heavy duty truck manufacturers in China, has shown interest for investment in the auto mobile sector of Pakistan. Ethanol Fuel: As the fuel prices are rising globally, Pakistan should switch to Ethanol Fuel as an alternative. Pakistan is one of the country which produces good quantity of molasses but the engines of the local cars do not support ethanol. Therefore, Pakistan should acquire the technology to produce ethanol compatible cars. Global spare part market: The annual gross sales turnover of the auto industry, at present, stands at Rs210billion while auto parts exports are estimated at $35 million. As such, the increase in production turnover is projected to increase by 185 per cent while the increase in exports of auto parts would also follow suit Threats: Competition from import cars: Auto industry is facing a threat from the import of cars which is already liberalized. However, the latest budget reflected increases in tariffs on imported used cars which might counter the impact of imported cars to a certain extent. Fuel prices:

According to the authorities, fuel prices will experience an upward trend in the near future, causing more worries for this industry. Tariff structure Government should formulate policies in such a way that it does not prove detrimental to the local economy and at the same time encourage the involvement of imported cars in order to maintain healthy competition. Smuggling of Auto Parts Due to a range of taxes and levies placed on automobiles and their parts, component manufacturers are having a tough time bringing their costs of production down and they are countering this issue with under-invoicing, misdeclaration and smuggling Threat of theft Rising security concerns in the country have led potential buyers to refrain from owning automobiles. Snatching of cars at gun-point is a good example of how theft discourage people from purchasing cars. Lack of financing Lack of consumer loans for car financing remains an issue. Even if there is financing offered by banks, the markup is too high which makes it unaffordable for potential buyers. Porter's 5-Forces Model: Level of Competition: Three major players i.e Suzuki, Indus Motors and Honda with other small players Mitsubishi and Mercedes. Suzuki is the biggest player, leading in terms of production units. Mehran, Cultus and Swift are some of its famous cars. Indus Motors ranks second in the market. Toyota Corolla is the most well-known car selling in the country. Atlas Honda is third in the market. Honda Civic and City lead this company while Accord follows suit. Other cars include Kia and Diahatsu. Threat of new entrants: The three big players have been well established in the market. Protectionist policies also counter the threat of entrants.

Honda’s first mover advantage in fuel efficient cars has caused an issue for potential entrants in this sector. Potential entrants should look to invest in other alternatives such as Biofuel, Hydro Electric and Electric powered cars. Economies of scale discourage the entry of new players. However, with the increasing costs of production, it is difficult to maintain economies of scale. Threat of Substitutes: This threat depends on to what extent companies invest in Research and Development. Alternative fuel cars like Biofuel and Electric cars have a strong potential to enter the Pakistani market due to rising costs of petrol and diesel. Trend is increasing for midsized and compact cars. However, this is still an urban phenomena. Big cars are still preferred by rural landlords. Bargaining power of Buyers: Buyers are price sensitive and have almost perfect knowledge of the market. The industry is oligopolistic with still heavy protection by the government Customers switch brands even with a small price difference. Customers demand after sale services and long term satisfaction as prices are usually fixed. Therefore, buyers are at an advantageous position relative to suppliers. Bargaining power of Suppliers: Most spare parts are imported and are from specific vendors. Therefore, companies do not have much incentive to switch their vendors. Similarly, suppliers abroad do not have the incentive to stop supplying as Pakistan is a strong market. However, suppliers for local parts are large in number, which causes a lot of competition in the local vendor market.

Financial Statement Analysis Starting off with Honda, their earnings grew by 4.4 times on the back of higher gross margin and higher sales because of the new civic and city models that were launched during the year. Although their net profit for FY14 was Rs. 1.07 billion, it is a huge step up from the Rs. 244 million they made last year.

The net sales for Honda were Rs. 39 billion primarily fueled by the 23,000 units of Civic and City that they sold this year, up 23% from last year. The main reason for the higher sales was the new shape of Civic and City Aspire 1.5 L that was launched, and this sales figure will go down for the new fiscal year because of the launch of the new shape of Corolla. It is expected to go down further if the age limit of used cars import is relaxed to 5 years again. However, their profitability is still expected to stay strong because of the rise in Gross Profit Margin because of the appreciating Pakistani currency. Around 70% of Honda’s CKD, including duties and taxes, is denominated in USD so any changes in its value have a strong impact on the performance of the company. The impact was so drastic that their gross profit margin, which was just 4.78% in FY13 jumped to 7.3% this year, and this is not even the entire scope of the benefits because the appreciation of currency was only realized for 3 months in the current FY so in the future the profitability is expected to be strong. They had a gain of PKR 397 million on their previous payables that were denominated in USD. On the other hand, Indus Motors sold more units in just 9 months of FY14 than Honda did in the entire year, which shows the strength of their higher market share. The company sold 26,700 units in the period with sales of Rs. 44 Billion. Around 50% of the cost of car of Indus Motors is denominated in USD and because of the depreciation of that currency against the Pakistani Rupee, their gross profit margin also rose to 8.9%. There has been a lag in the improvement of gross profit margin because of forward agreements for exchange, but a more material gain will be apparent by the 3QCY14, around the time when the new model is launched. Sales have been strong backed by the cut in prices from 20,000-75,000 across the model range, and are expected to grow substantially with the launch of the new shape of Corolla in 1QFY14. The price is expected to be between Rs. 1.9-2.6 mn across the model range. The company is planning to assemble the transmission for the new model of Corolla locally along with fuel tank parts, which will also reduce the cost and increase their margins. Sales of Fortuner have fallen because of additional 10% FED and the higher registration charges for vehicles over 1800cc. The company has sold just 6-7 units of Prius while it had invested a sizable amount in bringing it to Pakistan, hence that revenue has not been realized yet and it seems difficult because the price of imported used car is less than half of the price the company is offering it at. Pak Suzuki CKD cost is denominated in JPY and makes up about 30% of the total car cost, lowest amongst the other makers because of high level of localization. Therefore Suzuki was not able to realize a huge gain because of the slight depreciation of the JPY. Their Gross Profit Margin

stands at about 6.1% for FY13, which rose to 7.08% for 1QFY14 and is expected to rise further in the 2Q as old inventory is consumed. With hike in GST rate on tractor implemented from January 2014, MTL’s monthly sales dip to two year low in January to reach 189 units, but has since then picked up to 1,060/2,066 units in February/March. Tractor sales in Apr’14 reported a growth of 49% MoM to 4,460 units for the overall industry while MTL remained the volume leader in this segment capturing 65% market share taking the Apr’14 sales to 2,907 units. In the upcoming budget, the federal/provincial government may offer a new tractor scheme to boost agricultural growth which has been below par in FY14. The government will eventually have to implement a farm mechanization policy for increasing per acre yield in order to ensure food security in the country since farming is just not a profession but an effort to ensure food security for the population and with the added export orientation, the tractor industry is expected to perform well in the future. Trucks and buses segment remained flat at 302 units on MoM basis while recording significant growth of 58% on YoY basis. Within the segment, Hino’s sales rejuvenated by 55% YoY to 144 units. Cumulative 10M sales grew by 29% YoY to 2,486 units.

Key Business Drivers and Industry Dynamics

Availability of Financing Options In 2014, we can observe an increase in consumer financing for auto sector, because a number of private banks aggressively marketed their auto financing services. Another reason for this was the fact that segmented marketing was done rather than mass marketing, which created an increase in auto demand within specific consumer segments.

Consumers can finance the cars they purchase on the basis of cash or through financing options provided to them by different banks. In Pakistan, there has been a lot of growth in the availability of consumer financing specifically in the Islamic Banking sector, which increased the demand for vehicles over the past decade. Furthermore, the reduction in interest rates from 2002 to 2004 created a much needed boost for auto sales in the period. Hence, financing options are a key driver for domestic demand in Pakistan.

There is however, a noticeable slump in sales and demand for financing as result of the increase in interest rates from 2008 to 2009. Hence, an increase in the interest rates will negatively impact the automotive sector as consumers deviate from buying cars through bank financing as a result of the higher foreseen interest costs.

Amongst the different financing options available to consumers, a popular one is Car Ijarah. “An Islamic Ijarah is an asset-based contract, i.e. the Lessor should have ownership of the asset during the period of the contract. Under Islamic Shariah, all ownership related rights and liabilities should lie with the owner while all usage-related rights and liabilities should lie with the user.” 1

On the canvas of the Pakistani economy, automotive industry occupies a prominent place. Due to its deep forward and backward linkages with several key segments of the economy, automotive industry has a strong multiplier effect and is capable of being the driver of economic growth. A sound transportation system plays a pivotal role in the country's rapid economic and industrial development.

Exchange rates of Rupee versus other currencies As the rupee depreciates against the dollar and yen, the cost of production for local manufacturer’s increases. This is because many parts are imported from Japan and other countries. For example, if the rupee depreciates against the yen, the cost of assembly for Pak Suzuki Motors (PSMC) will increase and result in higher costs. Hence the volatility of the Pakistani rupee has a significant impact on the business performance of the companies in the domestic auto sector.

1 http://www.meezanbank.com/islamiccarfinancing.aspx

Though the recent rupee appreciation has caused carmakers to reduce their prices, the companies claim that depreciation of the rupee in the future will cause them to raise prices again. The strengthening of the rupee against the dollar and the further weakening of the yen resulted in an 87% increase in the earnings of the sector. Along with this there was an impact on the prices whereby Indus Motor Company and Honda Atlas reduced prices by up to 0.5%. However, because of the low demand penetration of the auto sector, fluctuations or reductions in prices may not have a very significant impact on the revenues of the companies unless the sales volume is increased by a large factor through aggressive marketing and changes in local consumer preferences.

Generic Factors The Pakistani automotive industry comprises of automobile and auto component sectors and is one of the key drivers of the national economy as it provides large-scale employment, having a strong multiplier effect.

• Growth Drivers of Pakistani Automobile Market • Rising industrial and agricultural output • Rising per capita income • Favorable demographic distribution with rising working population and middle class

Urbanization • Increasing disposable incomes in rural agricultural sector • Availability of a variety of vehicle models meeting diverse needs and preferences • Greater affordability of vehicles • Easy finance schemes / lower rates • Favorable government policies

Economic Conditions: When economic conditions are favorable, people are more likely to purchase new vehicles giving momentum to the industry. Slowdown in economic output leads to reduced consumer and business confidence and levels of vehicle consumption goes down.

Automotive manufacturers need to plan capacity to achieve economies of scale. Companies plan their capacities based on their sales predictions which are totally dependent on economic cycles. The capacity issue has a strong influence on industry economics as vehicle prices are calculated on forecast capacities and reduced capacity means higher unit costs. Vehicle makers, therefore, get heavily impacted due to economic conditions.

Government & Regulations: Legislation is a major driver of the industry; emissions and recycling legislation have a strong impact both on vehicle technologies and construction. In many countries, governments have imposed strict environmental regulations dealing with fuel economy and emissions control on auto manufacturers. These environmental legislations vary in different countries and define standards that are compulsory for all vehicles sold in those countries. This has huge impact on global auto manufacturers as they must keep updating the products they sell in different parts of the world to comply with these regulations. This can add significantly to manufacturing costs.

Consumer Demand and Interests: There is a growing demand for more choice. Volume production may become similar to that for premium cars, with a greater number of vehicles being made to order on the basis of a multi-option choice. The market for niche vehicles is growing, as consumers demand more variation of body shape and styling. This has led to a variety of body shapes being constructed on standard platforms.

There is an increased awareness of occupant and pedestrian safety, and consumers also look for greater fuel economy, exemplified by the growing rise of fossil fuel prices. Consumer are becoming more aware of specifications and looking for inclusion of more on-board electronics and telecommunications systems. Automobile safety is tremendously important to consumers in all markets and consumers are willing to pay more for vehicles with safety features.

Technological Innovations Companies seek to take advantage of sophisticated technology to address the competitive pressure and to meet increased customer expectations on quality and cost. Technological advances help them add value to their vehicles and offset the squeeze on costs and profit margins. Technology also helps them meeting the demands of environmental legislation. It is through technology that manufacturers are able to address consumer demands for increased safety and sophistication.

Problems faced by the industry and suggested solutions

Import Tariffs and Domestic Competition The automobile industry of Pakistan faces many issues and there has been a negative growth trend due to economic factors, high taxes and the energy crisis which increased the costs. Even though some conducive policies have been introduced, consistency must be ensured for long term growth. From 2006 to 2007, the car production was 220,000 but it reduced to 170,000 as a result of increased used car imports. According the budget 2014-2015, the GST on tractors was decreased from 16% to 10% and the 10% federal excise duty was withdrawn on locally manufactured vehicles over and above 1800cc. This has been done to improve the situation of the domestic industry while maintaining sufficient competition. As a result of the proposed reduction in the GST, the overall sales of the tractors and locally manufactured vehicles will be boosted.

There has been a discord between the protectionist policies that have been adopted by the government for the domestic sector and the new tariff rationalization policies that have been announced in the Pakistan Budget of 2014-2015. First we will review the problems faced by the sector in a historical context and then analyze the recent policies in light of that.

A major issue of the automotive industry was that the industry structure was oligopolistic in nature and this has led to rent seeking behavior by the few players in the market. Within the sector, there was a difference between the competitiveness of different products.

The motorcycles sub-sector was sufficiently competitive with a Herfindahl index of 1170, which revealed that there was moderate market concentration within this subsector. However, for other subsectors such as Motor Cars and Trucks, the Herfindahl index was exceedingly high and

showed that the market concentration was too much for healthy economic competition to exist.

Inconsistent Policies of the Government

Another issue is the lack of consistency in the policy framework. There were over thirty changes in the policy from 1994 to 2000 and the industry could not grow as a result of the volatility in the policy framework. However, the situation was markedly improved after the government adopted a uniform policy framework which increased the growth rate of the industry.

Lack of Consumer Power As a result of the lack of competitiveness in the sector, the prices of the vehicles were not sufficiently low for the consumers. Furthermore, the prices were higher in Pakistan as compared to other countries such as India and China. The situation was improved as a result of the rupee depreciation in 2014, which reduced the costs but the manufacturers still charged relatively higher prices by reasoning that the material cost was high and the problems brought in by the energy crisis. Another problem was the cartel formed by the domestic key players. The manufacturers’ priority on profits versus customer satisfaction resulted in them charging very high prices which transferred the losses to the consumers. Along with this, efforts were made by the companies to persuade the government to introduce protectionist policies for the domestic sector, so that they could maintain their power over the customers

Poor Exploitation of Potential Demand For every 1000 people, there are only 8 cars available in Pakistan according to a recent study. As depicted in the figure this specific number is very low compared to countries such as China and Indonesia. The market has not been properly penetrated by the local industry and we can see that there is a lot of unexploited potential within the industry. The only way for local manufacturers to increase the market share was to provide differentiated products in terms of quality or higher number of features. However, the focus on profit maximization has led to reduced emphasis on marketing and advertising strategies causing lower demand and selling of high price vehicles at the cost of lower sales.

Energy Crisis The circular debt and the energy crisis caused many problems for the automotive sector. As the industry is highly mechanized, the reliance on electricity has increased the costs of production for local manufacturers and hence reduced their competitiveness with foreign imported cars. This has led to even higher prices of domestically manufactured cars resulting in lower demand and lower sales. The government has reduced the protectionist policies of the past, and rationalized tariffs on car imports. All this has led to increased competition from international players, and the higher costs have only led to lower profits for the automobile manufacturers.

Proposed Solutions

In order to respond the problems faced by the auto sector, a focused effort must be directed by the government in collaboration with the local manufacturers and policy makers. The main issue being faced by Pakistan, is the information asymmetry that exists between different entities and the self-interest motivated decisions which result in bad outcomes for all the people. Hence, dialogue between the local firms and the government must be increased. Furthermore, the institutionalization and corruption must be reduced and prevented by the current PLM (N) government led by Nawaz Sharif. In light of the issues highlighted above, a number of steps will now be proposed for encouraging the growth of the auto sector in Pakistan.

The interest rates should be reduced and domestic Islamic banks should be given subsidies for provision of financing schemes to auto customers. This will lead to increased demand and higher sales. The circular flow of income, will create employment, leading to higher GNI and GDP per capita, and growth of the automotive sector. Furthermore, banks should focus on segmented marketing of financing schemes so that more and more relevant customers are

attracted. Particularly, financing schemes should be marketed to the middle and lower income segment which is highly responsive to the availability of financing options.

The rationalization of the tariff rates for car imports should be continued in order to drive competition within the domestic industry. However, at the same time, the government should adopt a more stable taxation policy which is not damaging for the domestic companies and is imposed while keeping the needs in light. Frequent changes in federal excise duty should be reduced and the general sales tax should be reduced further to increase the demand.

In order to reduce the cost of production, the government should open up trade with India. Domestic firms can import parts from India instead of China or Japan, which are considerably cheaper. Furthermore, the transportation costs would also be reduced. This will lead to lower prices of domestic cars and hence higher margins for the Pakistani auto industry. However, the political issues between the two countries has prevented open trade of auto parts till now. If the government of Pakistan can reach a favorable agreement with India, it will be very beneficial for the local auto industry.

The energy crisis and circular debt have also created problems for the automotive sector. The government should work on shifting the energy mix to other sources such as Hydro, Solar or Wind, so that the energy supply issue is resolved. With regards to this particular issue, the tariff rates on electricity should be raised so that DISCOs can make payments to IPPs and the issue of circular debt is resolved. Automotive manufacturers should also work on shifting their energy sources to renewable energy such as solar which would allow them to reduce their dependency on electricity from IPPs and hence, reduce their costs.

The automotive sector should work on improving the attractiveness of its products in comparison to imported cars. The companies should focus on product differentiation by increasing the quality of cars as well the number of features. Cost may be reduced by taking cue from Japanese production techniques such as Lean Manufacturing and Just in Time along with Total Quality Management (Kaizen). This will allow the companies to reduce their costs, thereby establishing cost leadership and at the same time increase demand through product differentiation.

Interview of a Practitioner in the Industry Mr. Babar Salim - Corporate Planning, Indus Motor Company What are your hopes and expectations for the Auto Industry Development Policy 2? We are hoping for a favorable policy to encourage further localization – We want them to encourage us – New entrants can come in but they should follow the same rules – If

Government favors new entrants it shouldn’t be at the cost of old players – Don’t penalize existing players by giving new players undue advantage – Everyone should follow the same duty and policies. It’s wrong to say the current players have a monopoly because prices are comparable to anywhere in the world. Do you think the Government’s stance to bring more players in the industry will prove to be constructive for the industry because of the competition or will it make each players size too small to be profitable? Competition is always constructive for the industry given that it is fair competition. We don’t think that it will make each players size too small because it will increase overall size of the market, the only thing is that the same policies should apply to old and new players both. What challenges do you think your major competitors, Atlas Honda and Pak Suzuki, pose to you? Honda is our direct competitor with the Civic and City models but Pak Suzuki is not in direct competition since we stopped production of Coure. If we come up with a car in the small car segment then they will be our direct competition again. But it is healthy competition and there is no problem with it. What is the basic overview of your supply chain? From which region do you import most parts? We source parts from a variety of sources - Multi sourced parts (MSP) are imported from Thailand, Indonesia or Malaysia – High tech parts are imported from Japan (JSP) - Locally we have 60 odd vendors – Tier 1 vendors are 30-40 What kind of regulatory framework is in place to ensure the safety and quality of the automobiles? There is incoming quality check and at the development stage they follow Toyota guidelines and all throughout the process so quality and standards are ensured - QAQC checkpoints at multiple stages – Functional checkpoints and any point on the assembly can stop the production if they find any flaw in the product that has come to them – There are road tests and pre-delivery inspection amongst a host of other checks. On the topic of recalls, we think they are not a bad thing because designers cant anticipate everything that will turn up in how customers will use the product so when we find out that something is causing a problem we take a stand to fix it hence it’s a good thing, responsible thing.

Do you see the industry going back to the mid-2000s level of sales and growth any time in the near future? We hope the industry will go back to the same levels – Economic indicators are going up – if there is industrialization then it will be beneficial for the whole economy – In trading only a few people make money at the expense of others so the focus should be on manufacturing so the whole economy will improve. What are the main factors that drive profitability in general, for the industry? It’s a volume game, scalability game – cost of production is reduced due to economies of scale – Currency depreciation has pushed up the cost of the cars, not that much increase in cost of production – Electricity, gas rates have had some impact though – security costs – expats or important engineers have to protected – fuel prices have also gone up along with minimum wages. In relation to how appreciation of Pakistani currency has improved margins : in long term the margins will return to normal because you can’t keep changing prices every few days so in the long run it balances out. What challenges in the overall business climate of Pakistan do you think pose a threat to your operations? Law and order, energy crisis – We took input from bankers who say customers are shying away from buying cars because of the poor law and order situation – unless the situation improves all sectors of the economy will suffer. If India is given MFN Status, how do you see that impacting the operations for your company? Scale of india is huge – they have economies of scale and hence cost advantages – all local part suppliers will have to go home if import of auto parts is allowed– whole industry will be out of business – MFN will not benefit our industry because India imposes non-tariff barriers, if they don’t want our products there so why do we ruin our industry to get their products here. Can you provide some information on the recent export order of 100 cars to Sri Lanka. One- off order between Government of Sri Lanka and GoP for Sri Lankan police and army and hopefully there will be more such orders in the future. I have read about the localization of the transmission of new Corolla. Can you tell more about localization efforts. 1.3 Manual Transmission will be assembled in Pakistan and fuel tank parts – Auto transmission will not be assembled here because there is not as much sales volume to for that yet. Hopefully there will be even more parts in the future.

New Product/Service Lines Pakistan With the rising costs of fuel on a global scale, one of the most important product lines would be the hybrid and fuel efficient cars. Honda has launched the CR-Z while Indus Motors has launced Prius. Even though sales of both brands is negligible, its a step in the right direction. Other brands like BMW are importing their ActiveHybrid range of cars through Dewan Motors including the 5 Series, 7 Series and X6. Porsche Pakistan has launched the hybrid Cayenne, Macan and Panamera. Overall, it is apparent that hybrid cars are the upcoming trend. Other than that, the liberalization of import of heavy bikes has also been a huge change in the past year. Suzuki started off by bringing their heavy bikes, most notably the Hayabusa. Honda quickly followed suit by importing the CBR range of bikes and now the likes of Aprilia are rumored to be coming to Pakistan officially. On a different note, another plan for the recent future is that of Yamaha motors. Yamaha is planning to make an investment of around USD 150 million in 2015 to launch its own motorcycles with an engine capacity of 100cc and above. There is huge potential for someone to launch a cheap car in Pakistan. Currently the price of the bikes is close to Rs. 70,000 while that of a car starts at around 6 lacs so there is no intermediate product. If someone can launch a car like the Tata Nano, there is huge scope for such a product. In addition, since the rate of mechanization in Pakistan is low, there is room for hand-assembled auto parts or complete vehicles that are of premium quality which can cater to the luxury market. Lastly, because of the law and order situation in Pakistan, the market for bullet-proof and bomb-proof vehicles is also growing at an astounding rate. Although some companies are already working on this, its a growing market with alot of potential. Automobile Industry across countries The recent introduction of the Tata Nano in the Indian market has opened up new possibilities. This car targets a whole new segment in the market for automobiles as it is the cheapest car in the world. The main target market is those families that used to own motorcycles and didn’t have the affordability to buy a proper car for their family. The Tata Nano has shown that there is a lot of potential in the automobile sector of other countries too for growth as this segment had been untapped before. Not only as a cheap car but as a small, compact urban car.

There is also a burgeoning market for hybrid and electric cars around the world. Other fuel sources are also being experimented like solar cars or hydrogen powered cars which can potentially turn into new markets.

Comparison with Regional Countries Pakistan’s automobile industry stands behind the auto industry of neighboring countries. Car prices are high, there is low production capacity, exports are low and the industry is disorganized. Japanese car manufacturers control most of the country’s passenger car production and sales. Countries like India and China are doing fairly well in terms of production and innovation, as compared to Pakistan.

India The Automotive industry in India is one of the fastest growing globally. India's passenger car and commercial vehicle manufacturing industry is the sixth largest in the world, with an annual production of 4.1 million units in 2013, which was 29 times that of Pakistan’s production of 0.14 million. The comparison of exports also shows Pakistan to be in a very disadvantaged position as compared to India. Where India managed to export USD 5 billion in the year 2012, Pakistan only exported automobiles and auto sector products worth USD 128 million. The local industry would face severe challenges if imports from India were allowed at lower custom tariffs in the future. Till the 90s, India had a closed economy which allowed the local automobile industry to grow by banning the import of imported vehicles. The size and success of the Indian automobile industry can be seen by the fact that Indian companies have even acquired big names like Jaguar. The largest car manufacturing industry of India is established in Chennai, also known as the "Detroit of India" with the operations of Ford, Hyundai, Renault and Nissan headquartered in the city and BMW having an assembly plant on the outskirts. Pakistan however has no such area which is particularly dedicated towards automobile manufacturing. India’s car, Nano by Tata, has enabled them to cater to the mass population who wanted an option between a bike and a big car. Finding such gaps in the market has led to an increased demand for automobiles in the economy and has allowed the industry to grow. Similar demand exists in the Pakistan market but that market is still untapped due to lack of innovation and also due to the fact that

our industry hasn’t been able to reach economies of scale. The Indian auto sector is expected to have a bright future ahead while the fate of the Pakistani automobile industry is still subject to debate.

China The last three decades in China have seen a tremendous growth in its automobile sector. The number of manufactured cars increased from 222,000 in 1980 to more than 18 million in 2011. China is now one of the top automobile producers of the world. International automotive companies aiming to compete in China also face significant challenges, mainly due to the low price advantage China has. The Chinese government plays a major role in regulating investment in the automotive sector and designs policies to accelerate the technology transfer to China. This has aided China in using the best technology to produce its cars. In Pakistan, the government hasn’t done much to boost the technology transfer or to encourage innovation. China’s strong economic performance has helped its automobile industry grow, as this sector needs a lot of financial support. Pakistan’s economic situation keeps worsening and is not that stable, yet it puts up a fight in the automobile industry.

Japan Compared to Japan, Pakistan is quite worse off when it comes to technology and innovation. Japan uses mass mechanization and high quality processes like Kaizen and JIT. The Japanese market has always dominated that of Pakistan. The progress of Japan’s automotive industry has surpassed that of Germany as well, and currently Japan is one of the largest industries in the world. The size of the industry can be judged by the fact that the auto-related employment in the country is 5.48 million people (2013). Pakistan has a direct employment of 215,000 people only, while statistics show that indirect and direct employment both come up to be around 2.2 million people.

While Pakistan imports auto parts and only assembles vehicles in the country, Japan manufacture both auto parts and complete automobiles.

Appendices http://www.thefinancialdaily.com/NewsDetail/157406.aspx http://www.jama-english.jp/publications/MIJ2013.pdf

http://www.saglobalaffairs.com/back-issues/288-pakistans-auto-industry-in-decline.html https://www.pakwheels.com/blog/2013/02/12/a-view-on-pakistans-automotive-industry/

Contact Details Mr. Babar Salim - Corporate Planning, Indus Motor Company Email Address : babar.salim@toyota-indus.com