Managing Director & Senior Partner; Global Leader, Global Advantage Practice
The Russian automotive industry has experienced significant ups and downs in the past decade. The domestic car market rebounded strongly after the global financial crisis to become the sixth-largest in the world—2.6 million automobiles (cars and light trucks) sold in 2012. Manufacturers responded by building new plants to expand production.
But the current economic downturn, caused primarily by falling oil prices, has hit hard. In 2015, the industry sold just 1.5 million automobiles, to rank 12th in the world behind such countries as Canada, the UK, and Brazil. (See Exhibit 1.) Today, as a limping economy continues to hold domestic buyers in check, the industry finds itself with far too much production capacity.
We analyzed the factors affecting Russia’s automotive market and developed three potential scenarios. In the most likely of these, the market recovers slowly by 2020 but annual sales still do not exceed 2 million automobiles. This level of sales represents a “new normal” for the industry, and it is far below the industry’s current production capacity. If automakers and component manufacturers are to avoid serious—and prolonged—financial losses, the industry must recalibrate.
Two measures can improve the situation. First, manufacturers should focus on exporting more vehicles to foreign markets, particularly in the Middle East and other developing regions. Second, Russia’s government should foster innovation in high-potential areas such as driver-assistance and connected-car technologies.
The automotive sector in Russia is an integral part of the country’s industrial base, generating about 1.2% of the nation’s total GDP from automobile and component manufacturing, sales, and services. Factoring in the supply chains of all subcomponents, which link to steel, plastics, electronics, and several other industries, yields a total economic contribution of 3.6%.
As the Russian market for cars rapidly grew in the years following the global financial crisis, foreign automakers sought to sell to the expanding audience of car buyers in the country. In response to this competition, the Russian government introduced several measures designed to support domestic companies—both OEMs and component manufacturers—and build up the industry.
For example, the government required foreign manufacturers to build their cars locally. A certain percentage of each car sold in the country had to consist of components built in Russia, and that percentage increased over time. But many companies got around these requirements by making large, heavy components in Russia while developing and building higher-value, more technologically advanced components (such as electronics) elsewhere. Other automakers sent nearly completed components to Russia, leaving their Russian plants the simple task of assembling them.
The end result is that Russia’s automotive industry has failed to build up its technical capabilities as the government intended. Russian manufacturers lag behind their peers in both mature and developing markets in areas such as labor productivity. Similarly, spending on R&D is much lower at Russian companies than at their foreign competitors. Today, Avtovaz spends less than 1% of revenue on R&D, compared with the 4% of revenue that most global auto manufacturers devote to R&D.
In addition, the country’s relatively strong rebound from the financial crisis spurred many manufacturers to boost their capacity by opening new plants. Overall capacity in the country reached roughly 3.1 million vehicles a year in 2015, with forecasts projecting that the market would reach an annual figure of up to 4 million automobiles. Since then, however, the Russian economy has slowed considerably, leaving the auto industry with too much production capacity and not enough technical expertise.
To see what the next five years could look like, we built a market model by analyzing the factors affecting the Russia automobile market, including oil prices, the dollar-ruble exchange rate, GDP growth, wages, and interest rates (which influence how easily Russian consumers can finance auto purchases). This analysis points to three likely scenarios. (See Exhibit 2.)
The optimistic scenario assumes that a rise in oil prices to about $60 per barrel will occur, along with limited growth in real GDP and wages, a favorable exchange rate, and a rapid drop in interest rates, leading to an overall market size of 2.2 million automobiles sold each year by 2020. The pessimistic scenario assumes that those metrics will remain level or get worse, yielding a market size of 1.5 million autos sold annually in Russia—and meaning no change from the current market over the next five years.
Our baseline scenario—which we believe is the most likely of the three—anticipates moderate improvements in oil prices, GDP, wages, and interest rates, leading by 2020 to a market size of 1.9 million automobiles sold each year. This is only slightly larger than the market size in 2010, one year after the financial crisis, and it is far below the country’s current manufacturing capacity of 3.1 million vehicles.
It is also below the breakeven point for Russian manufacturers, which we estimate at 2.4 million to 2.6 million automobiles. (See Exhibit 3.) At their current sales volumes, manufacturers are running their plants at only 40% to 50% of capacity, resulting in annual losses of 30 billion to 50 billion rubles per year.
The most obvious measures that companies might use to address this overcapacity are simply not sufficient. For example, exporting automobiles to countries in the Commonwealth of Independent States (CIS) is one possibility, but that market is small—just 300,000 per year now, though projections suggest that it may grow to 600,000 autos annually by 2020. Similarly, the Russian government could subsidize domestic car purchases. For example, it might give Russian consumers money to reduce the out-of-pocket cost of a new car. But such a move would be prohibitively expensive. Absorbing the current annual excess of 600,000 to 1 million vehicles would cost anywhere from 90 billion to 150 billion rubles per year.
But reducing the industry’s production capacity would be painful, too. We estimate that closing three to six manufacturing facilities would lead to the loss of between 14,000 and 54,000 jobs across all affected industries (including subcomponents) and reduce annual GDP by between 15 billion and 55 billion rubles.
What else might be done? We see two ways to overcome the industry’s current challenges: through exports and through innovation.
Exports. The first solution is for manufacturers to make an aggressive push into exporting. Some countries in the Middle East, such as Iran (which buys about 1 million automobiles a year) and Saudi Arabia (600,000 autos), have vehicle markets that are still relatively open and growing. Collectively, the African countries of Egypt, Algeria, Nigeria, and Mozambique account for roughly 800,000 cars a year. Moreover, European countries could be export targets for some car models produced in Russia. For example, the Kia Rio, a budget model built in Russia, could be sold in European markets such as the UK, Italy, Spain, and France (all of which are close enough to offer low delivery costs from Russia).
Hyundai/Kia is a good model for how to expand into exports. The Korean OEM has increased its annual sales from 2.3 million vehicles in 2000 to more than 8 million in 2015 (a compound annual growth rate of 9% during that period, which is an industry record). Hyundai Motor Company started with a strong position in its home country: a market share in Korea of 70% to 75% (due in large part to protectionist trade barriers), very high profitability, and a highly efficient network of suppliers. From that base, the company launched a strategic expansion into foreign markets.
Hyundai began with strong measures to improve quality. In the early 1990s, the company’s quality ranking was among the worst for any major manufacturer, but now it consistently ranks among the best worldwide. Hyundai also sought to develop new designs quickly, introducing seven entirely new models in just two years. It put forward the right value proposition for high-growth markets—entering the US market aggressively in the late 1980s as a low-cost brand, and entering fast-growing markets such as Brazil, Russia, India, and China in the 2000s. And it established a highly efficient network of suppliers and invested in its brand.
Innovation. The second approach to boosting the Russian auto industry is for the government to develop R&D centers in promising new technologies. Certain areas, such as electric powertrains (which would likely require an investment of billions of dollars and 15-plus years to get caught up), might be challenging because of their complexity and risk. But other areas, including advanced driver-assistance systems (ADAS) and digital connected-car technologies, are more attractive options.
Russia already has a foundation in place, with about 200 patents and seven startups focusing specifically on connected-car technology. One company, Remoto, designs apps that enable drivers to control features of the car remotely through their smartphones. Another, Movizor, is working on a system to track the location of vehicles. A third, Kot, offers automobile locator and safety systems. Russian companies are even more active in the mobility services marketplace, where 15 startups have collectively attracted more than $100 million in venture funding.
To accelerate innovation, the Russian government should try to persuade leading global OEMs to build R&D centers in Russia. This idea might seem ambitious, but three factors work in its favor.
First, OEMs are under constant pressure to reduce costs in all areas, including R&D. Offshoring engineers to Russia and other low-cost countries might be a realistic way to do so. For example, Volkswagen, Ford, Toyota, Daimler, BMW, and many others have opened R&D and engineering facilities in China. And foreign companies—mostly subsidiaries of European OEMs—have opened more than 30 R&D centers in India. Similarly, GM opened and recently expanded an R&D center in Israel, a country that doesn’t have any vehicle production capacity but offers strong engineers and cutting-edge technologies.
A good example is Mobileye, an Israeli company that develops advanced driver-assistance systems to help prevent and mitigate collisions. Mobileye sells its products to 20 auto manufacturers around the world, and those companies have added the technology to more than 250 of their models. Mobileye is even developing a semiautonomous vehicle, which it plans to release by 2020, followed by a fully autonomous vehicle by 2026.
Second, companies in other industries have already established R&D centers in Russia. Among the companies that have done so are Boeing and Airbus (in aviation), Schneider Electric (in energy), Bosch (in manufacturing), and Cisco, IBM, and Intel (in IT).
Third, Russia has expertise in many of the underlying technologies required for ADAS and connected cars: IT, radio optics, and modeling and acoustics. And it has a pool of talented, entry-level engineers whose average salary is one-fourth to one-third that of their counterparts in developed markets such as the US and the countries of the EU.
For Russia’s auto manufacturers to succeed at exporting and innovation—and to return to the growth profile they experienced in 2009 and 2010—Russian authorities must work closely with industry leaders. To that end, the government should initiate a series of roundtable discussions with industry representatives, addressing ways to accomplish four objectives:
In addition, we suggest that the Russian government adopt several other measures. First, it should clearly define the requirements for R&D localization, not only in terms of specific capabilities but also through quantitative metrics such as spending as a percentage of revenue, and number of local employees. The government should also incentivize OEMs to develop R&D in priority areas, potentially by expanding existing subsidies such as tax benefits.
And finally, government authorities should spur entrepreneurship and create favorable conditions for startups. Doing so might entail investing to improve infrastructure (for example, automotive clusters linked to R&D centers that offer needed equipment and services). The government might also help strengthen ties between universities and businesses, give entrepreneurs better access to global OEMs, and increase the availability of private-sector funding.
Whichever option the government chooses, it should decide and take action quickly. Increasing exports and fostering innovation are not easy tasks, but the current approach—in which foreign companies ship nearly completed components into the country and merely assemble them locally—is a losing game.