Engine of growth – how car industry is investing in enlargement

Date: 06/05/04

ACROSS swathes of the EU's new member states, the muddy farmer's field still reigns supreme and the tractor, rather than a sleek SUV, coupé or convertible, remains the everyday transport of necessity.

Yet (and whisper it quietly lest the environmentalists overhear) the car industry is helping to drive our central European compatriots out of poverty.

The world's carmakers were attracted to the former Soviet bloc countries by low tariffs for exports to western Europe and state incentives when the Berlin Wall was felled.

When EU membership became a prospect, most decided to stay put: buoyed by entry to the world's largest free-trade area, pumping even more money into car production and in turn nurturing local communities.

The result is that factories have more in common with 21st-century Detroit than the Soviet-era smokestacks they replaced. Volkswagen (VW) has invested millions in the Czech Republic, transforming Skoda into one of the EU's most trusted car brands, selling nearly half-a-million models per year. France's PSA Group is setting up a $1.4 billion (€1.2bn) joint venture with Toyota (Japan) in Kolin near Prague, to make small cars for the European market from 2005.

In Slovakia, VW is churning out Polo, Golf and new Touareg cars as fast as eager customers can snap them up. VW's Audi unit in Hungary, which mainly makes engines, accounts for around 3% of that country's exports.

Japan's Suzuki has become the biggest automotive investor in Hungary. Its Magyar-Suzuki factory grew gradually in the 1990s, initially assembling cars from imported components. The company now sources the majority of its parts from Hungarian-based firms, giving the cars duty-free access to the EU.

Renault has plans to expand its Clio plant in Slovenia. Meanwhile, over in Poland, General Motors, the world's biggest carmaker, screws together its tiny Agila model, designed by Suzuki - though Italy's Fiat has had a tough time and has been forced to lay off staff.

The economics of investing in the EU's eastern fringes are compelling, says Tim Armstrong, senior analyst for eastern Europe at economic and market forecasting company Global Insight.

"Especially for small cars, where the profit margins are the thinnest. Production is focused not on local markets but as an export location back to the West. Production costs are significantly lower with wages at most 20% of current EU levels.

"And the logistics for supply to the German market are much better than from Spain and Portugal which attracted investment [from VW] in the 1990s," explains Armstrong.

But it's not all for export. The roads may still offer what the auto journalists call an "interesting ride". But locally built Skodas and Suzukis, bolted together in state-of-the-art neighbourhood factories, are bestsellers in the Czech Republic and Hungary.

The economic case for shifting to central Europe is even stronger in the component supplies business where margins are even thinner than in the mini-sized or "A category" car sector, says Armstrong.

The clamour to invest eastwards has led to fierce competition among new member states to attract car- company money, using a combination of low corporate taxes, tax holidays, "regional investment zones' and subsidies.

Slovakia and Poland have just slogged it out for €800 million investment from Korean conglomerate Hyundai to build Kia brand motors. The two squared-up last year to attract a new plant for France's PSA Group. The Slovaks won on both counts.

The Kia factory, which will open in 2006, will produce up to 200,000 vehicles every year in the north Slovak city of Zilina.

PSA said labour costs had persuaded it to pick Trnava in western Slovakia for its €700 million small car plant.

"The Poles did not get any of that because their government was flapping around they were trying to protect Daewoo, which is struggling, rather than attracting investment," says Armstrong.

The Polish arm of Daewoo was not part of GM's global take-over of the Korean brand and is expected to flop sooner rather than later.

"The others were marketing their stability and showing that their logistics are as good if not better and that they had the components [suppliers close by]."

Joining the EU means meeting the terms of the Union's strict state aid rule book. But Armstrong reckons the new member states and the firms that were handed public funding in exchange for setting-up factories need not worry. He said countries are allowed to give subsidies amounting to around 15% of the cost of setting up a plant.

"I don't think they are in substantial breach [of the state aid rules]. Previous agreements have been renegotiated, such as the one between General Motors and Poland. And the Slovaks are saying that it is all legitimate."

Further east, Romania - hoping, rather optimistically, to join the EU club as early as 2007 - is also getting in on the car act.

But experts are more doubtful that Renault, which took over the country's biggest car company, Dacia, in 1999, will be a magnet for massive capital expenditure - at least when it comes to producing cars for export to western Europe.

Romania is seen as too far east to compete with the likes of Slovakia, even if it could compete on the quality of its workforce and infrastructure.

A better bet for Renault will be to target the huge Russian market and potential customers further afield, such as Iran and the former Soviet republics in central Asia.

All of the new member states will join the euro currency at some stage. And membership, or not, of the eurozone is likely to have an impact on investors' attitudes.

One danger is likely to be the rate at which the countries peg their domestic currencies to the euro in the ERM II (exchange rate mechanism) - designed to prepare states for adopting the single currency.

If governments choose too high a rate, there could be exciting times in the foreign exchange markets. Speculators are already sharpening their claws.

On the down side, all this could lead to increased volatility - anathema to car company bosses, who regularly chastise the UK for staying out of the euro.

On the up side, if the traders do push down the value of the new countries' currencies, the economics of producing for the export market will become even more attractive because their output would be cheaper still.

Another danger is likely to be the action that the governments are forced to take in order to get their finances in order. The EU's Stability and Growth Pact stipulates that budget deficits stay close to zero. Most, such as the Czech Republic (12.9%) are far from that.

Barring miracles, balancing the books will require tough fiscal austerity, which could dampen local demand and ration any special tax perks on offer.

A recent report by the Economist Intelligence Unit has warned that overcrowding in central Europe could drive investment elsewhere. It cited CzechInvest, the Czech inward investment agency, which conceded that the country could probably only absorb one more major car plant.

And with two large companies operating at full capacity in Slovakia after 2006, there may not be much room for another plant there either - at least in the western part of the country.

The overcrowding may force investors to shift operations into the Balkans and Commonwealth of Independent States, where labour is cheaper still, the report warned.

But perhaps the biggest nagging fear is that car company bosses might wake up one day and decide to up-sticks entirely to China, where labour is even cheaper.

To decide, bosses must weigh the cost benefits of switching production to China against the hassle of being so far away from the western-European market.

For the time being, wages in manufacturing are still way below central European levels and far cheaper than Slovenia. However, "hot-spots" in China are wiping out some of the cost savings for companies with Chinese plants, such as VW.

At the moment, manufacturers are opting to invest in central Europe for sales to western Europe, while supporting investment in China to service local Asian demand. The upshot, says Armstrong, is that a switch to China is not on the cards. "This is long-term investment. They won't move. The advantages are still significant."

Cue much blasting of horns from Warsaw and Bohemia to Bratislava.

Stock of passenger cars per 1,000 people

Bulgaria: 293.16 (2003), 311.83 (2004), 331.6 (2005), 352.72 (2006), 375.32 (2007), 399.59 (2008);

Czech Republic: 323.44, 321.98, 323.8, 326.74, 330.53, 335.28;

Hungary: 262.16, 277.28, 292.43, 308.48, 325.17, n/a;

Romania: 165.28, 175.04, 186.45, 199.30, 214.20, n/a;

Poland: 272.38, 281.52, 290.49, 299.89, 309.32, n/a;

Russia: 151.57, 156.46, 161.83, 167.59, 172.91, n/a.

Source Economist Intelligence Unit

The cars are the stars in the battle against central European poverty.