Japan's Catastrophe Unlikely to have Immediate Impact

However, cost-push inflation could impact profitability of some OEMs

ICRA

The recent catastrophe in Japan may not adversely impact the production of automotives and auto-components in India in the immediate term, but its impact over the medium to long term remains to be seen. The several challenges that could emerge in the aftermath of the earthquake and tsunami include: (i) disruption in supplies of vehicles and vehicle assemblies to India; (ii) cost pressures arising from appreciation of the Japanese yen; (Hi) delays in model launches; and (iv) delays in investment by Japanese players in the Indian market. These challenges would only add to the difficulties arising out of: (a) the increasing trend in the prices of raw materials, especially steel; (b) the rise in interest rates that Indian automotive manufacturers are already grappling with; and (c) the increase in customs duty on pre-assembled engine and gearbox or transmission mechanism that took effect from April 1, 2011.

The Indian automotive and auto-ancillary industry has strong linkages with its Japanese counterpart, being characterised by the presence of several Japanese original equipment manufacturers (OEMs) and ancillaries through their subsidiaries and joint ventures. Additionally, there have been various efforts by the Governments of both countries to encourage bilateral trade and investments, the most recent being the Comprehensive Economic Partnership Agreement (CEPA) signed by India and Japan in February 2011.

While the Indian subsidiaries of Japanese OEMs in the two-wheeler segment and most players in the domestic commercial vehicle (CV) segment have relatively high levels of indigenisation and thus, limited dependence on imports, some of the OEMs (and the ancillaries) in the passenger car segment continue to have moderately high import dependence. The extent of import dependence in passenger cars is, however, a function of the scale of operations of these OEMs. For instance, Maruti Suzuki India Limited (MSIL), the largest passenger vehicle OEM in India, has very high indigenisation levels as it has been operating in the country since 1983, and is fed by various "local" auto ancillaries that have grown around it over the years. But there are several other global OEMs (including from Japan) as well that have a smaller scale of operations in India and these players are yet to reach the desired indigenisation levels. They remain dependent on imports of critical parts (like engine and transmissions parts and assemblies) and select models (completely built units).

In the case of some OEMs that depend on component and model imports from Japan, they also have, or have identified, alternative sources for imports, such as the transplants in various South Asian countries like Thailand. This, in ICRA's view, would limit the impact of plant shutdowns in Japan as far as availability is concerned. But from the point of view of costs, with the demand for components from facilities in these alternative locations shooting up, some importers may find obtaining competitive bids difficult, which in turn would push up costs. And this increase in costs, were it to happen, would come on top of the escalation caused by the higher import duties (on pre-assembled engine and gear box) that kicked in from April 1, 2011.

As for some of the premium/luxury car models that are dependent on imports of higher-grade automotive steel from Japanese steel makers (who have announced plant shutdowns in the aftermath of the catastrophe), the impact would depend on the duration of the plant shutdown. If the plants remain shut for an extended period, production of specific vehicle models in India could be hit.

Impact of production cuts and supply-chain disruption in Japan on Indian auto/ auto-ancillaries

While production at the various sites of automotive OEMs and auto-ancillaries in Japan was halted for a few days beginning March 11, 2011 in the aftermath of the catastrophe and news came in of outbound shipments of some companies having got destroyed, ICRA believes that these events are unlikely to adversely impact automotive production in India in the immediate term as the various Indian importers maintain sufficient stocks (10-30 days' inventory) and some stocks are currently in transit (high seas).

Additionally, the Indian auto-ancillaries and OEMs are monitoring the developments and identifying alternative locations for sourcing electronic components (the most affected product segment). However, if the restoration of production in Japan takes longer, this may lead to shortage of select parts (technology intensive and proprietary parts, for which alternative locations may not be available) and impact the production levels of those models in India. Over the next few months, ICRA will be monitoring production at most automotive and auto-ancillary facilities in Japan, which would be a function of the reconstruction initiatives at plants and on the infrastructure front (roads, railways, ports), besides the availability of vessels for transportation and such other factors.

 
Among auto-components, there are several for which select parts are imported from the technology collaborators, especially, during the technology adaptation stage and subsequently localised, while there are components that being proprietary products continue to be imported. While for most components, Indian players have indigenised the technology, in the case of technology-intensive products (like critical engine parts, transmission parts, steering systems) or those that require use of proprietary components (car air-conditioning systems, friction material in clutches, and shock absorbers) the import dependence remains moderately high. This is also on account of the significant production capacities that have been created in the Asian region from where imports into India are possible. ICRA believes that most import dependent auto-ancillaries have maintained adequate inventory levels (as the lead time for imports is high) for immediate production purposes. ICRA, however, would continue to monitor the reconstruction activities in Japan over the next few weeks.

Impact on investment plans: The robust growth in the domestic passenger car segment over the last decade has attracted a large number of global OEMs (Volkswagen, Nissan, etc.) to India and encouraged those that had come in earlier (such as General Motors, Ford India, Toyota, Honda) to increase their investments and widen their product portfolios here. While many of the global OEMs have entered India to cater for the domestic market, some have also invested, or plan to invest, in developing their Indian operations into an export hub. Following these OEMs, a number of auto-ancillaries have also invested in, or are in the process of setting up, manufacturing facilities here to meet the requirements of the OEMs concerned. Additionally, many Japanese auto-ancillaries that had initially established manufacturing facilities (during the 1980s and 1990s) in India as minority stakeholders (when the volumes were low in the domestic car market) are now setting up new units as majority stakeholders or fully-owned subsidiaries.

Some of these new manufacturing units are making large imports from Japanese and South Asian plants to begin with and have plans to localise the components over the medium term. Now, with the Japanese supply chain disrupted by the catastrophe, the plans of some of these players to invest in India may get deferred. Further, some Japanese players have developed products (especially, small cars) for the Indian market, and some of these products are currently undergoing testing and validation at the OEM and auto ancillary locations in Japan. The closure of facilities in Japan for a few days can delay the launch of these products in India.

Impact of volatility in INR-yen rate on financial performance

 
Supplies to India apart, the issue of volatility in the rupee-yen exchange rate may impact the financial performance of OEMs and auto ancillaries in India, especially those that have not hedged their exposures. This applies not only to direct imports from Japan but to all yen-denominated imports. However, the impact of such adverse movements in the exchange rate is also likely to be muted by two factors. One, the already hedged exposures (at least for next two-three months) of several OEMs and ancillary players who had seen their profitability take a hit from the appreciation of the yen during the last two years. And two, the likely passing on of the increase in sourcing costs because of yen appreciation to OEMs by ancillaries and to customers by the OEMs. Still, not all exposures have been hedged and not all the increase in costs can be passed on to customers.

Conclusion

While the domestic automotive industry has posted strong growth across segments during 2010-11 so far, the cost-push factors such as higher commodity prices, foreign exchange volatility (especially with respect to the yen) and increase in the landed costs of imports (specifically for players with a high dependence on imported assemblies) are some factors that may adversely affect the financial performance of automotive and auto-ancillary players over the short term, given that the OEMs are unlikely to be able to pass on the increase in costs to customers immediately.