India as a Global Base for Automotive Manufacturing and Services - The Domestic Challenge

KPMG Survey

(This is the conclusive part of the KPMG Survey released in January 2008)

Indian auto companies face favourable domestic conditions: a vehicle market growing considerably faster than GDP growth, which itself is very strong; a phase of economic modernization which is bringing easier finance with it; and increasingly favourable consumer behavior, as well as a new round of auto-supportive infrastructure improvements.

However, there are also challenges: growth in India and the rest of Asia is bringing tougher competition at home, and competition for investment is intensifying from emerging producers like China. Indian automakers face the challenge of establishing their brand credentials; global companies will have to work hard to fulfill their profit potential so long as India's physical infrastructure and business environment remains at best only partly rebuilt and reformed. These are the themes of the three propositions on India's domestic challenges that we put to leading automotive executives in this report.

 
The Indian domestic market will continue to be dominated by small cars

Passenger car sales in India have grown by almost 15 per, cent CAGR over the last five years, with growth concentrated in the small car segment. Will India remain a predominately small car market, or trade up to higher specification medium-sized vehicles?

Indian car buyers' preferences are changing. "A few years ago Indians would never pay for luxury, but now they will," comments Sunil Rekhi of General Motors.

New car registrations have grown from 625,000 in 2001 to over 1.3 million in 2006. The sub-1500 cc or 'mini and compact car' segments account for over 66 per cent of new sales - the Maruti 800 was the best selling car in India for a number of years before ceding the position to another sub-1500 cc car, the Maruti Alto, in 2005. (Figure 17)

Carmakers are investing accordingly: Toyota has announced plans to set up a new small car manufacturing plant by 2010 with an annual capacity of 100,000 units. Hyundai, Tata and Ford have also announced small car manufacturing expansion plans.

"Customers want more quality and they want more comfort," says Suhas Kadlaskar of DaimlerChrysler. "They are even calling for more power - this was something that was unheard of just a couple of years ago." But Kadlaskar believes this trend is seen primarily in the shift: from two-wheelers to cars, rather than the purchase of larger cars. ''The main trend is that people are migrating from two-wheelers to four-wheelers," he says.

Affordability shapes the Indian passenger car market. Indian lenders are typically willing to advance between three and four times household incomes in car finance loans. That rate of borrowing combined with forecasts of household income from NCAER suggests that it is the small car segment that will continue to dominate the passenger car market, with almost 50 per cent of households being able to afford an A1 or A2 small car by 2009, compared with less than 15 per cent able to afford a mid-sized car. (Figure 17)

Figure 17. Auto Affordability Forecast

Households which can afford a particular car-segment
Segment	Price (USD '000')	2005	2009
Segment A1 & A2 (Mini & compact)	6.25 - 12.5	35.06 per cent	48.46 per cent
Segment A3& A4 (Mid Size & Executive)	12.5 - 30.0	8.9 per cent	14.53 per cent
Segment A5 & A6 (Premier & Luxury)	Over 30.0	2.43 per cent	4.5 per cent

Source : KPMG International, 2007

 
The small-car segment will also benefit from recently introduced tax incentives, cutting central excise duty on small cars to 16 per cent (compared to 20 per cent for larger models). But responses to our survey suggest that the majority of auto executives (65.5 per cent) believe it is affordability in terms of household incomes that will ensure that India remains overwhelmingly a small passenger car market in the next five years.

"I believe India will remain a small car market," says a senior executive of Endurance. "Thanks to the small cars being produced by Tata and others there will be 15-20 per cent growth in this market. The medium-size car market will grow but the small car segment will grow a lot faster."

In interviews, companies identified two critical issues for the growth of the small car market:

▪	Affordability & Credit: In Indian terms even small cars are costly - the average small car costs around 12 times average annual disposable income. A K Taneja of Shriram Pistons believes that affordability will restrict sales growth of larger cars in the foreseeable future: "Small, fuel efficient cars will remain the main market," he says. "It is not only a matter of the cost of the vehicle in the showroom, it is also the total cost of ownership. But what is changing is that vehicle demand used to be driven by government, by institutions and private companies - now it is being driven by private, middle-class consumer demand. And for this set of consumers, affordability is the key issue." A senior executive of Endurance says that financing and taxation will continue to shape the market for larger cars, arguing, "The medium segment is still dominated by company cars, the sort of thing that medium- to high-level managers get. Either companies buy fleets, or they offer employees finance. And in this segment a lot will depend on whether there are new fringe benefit taxes."
▪	Attitudes: "Indians are savers, they are frugal, they are cost conscious, and they are very driven by value for money," says AK Taneja of Shriram Pistons. Most companies believe that this means that medium sized cars will remain hard to sell in volume - but that despite the conservatism of consumers, attitude changes will drive small car sales. “There is a huge social shift in India," says Shriram Parameswaran of Eaton. "People are coming from rural areas to the cities, two-wheelers are giving way to four wheelers, and as a result the very small 800-1000 cc car market is going to grow very fast. Plus we are moving to an era of dual incomes, husband and wife both working, and we are also seeing new concerns about two-wheeler safety that support small car sales."

 
A growing percentage of vehicles in the Indian market will run on alternative fuels

Alternative fuels and the vehicles that use them are now high on the agenda for the global auto industry with new alternative fuel initiatives already in place in Europe, the U.S. and South America. Will India develop as a significant market in this emerging sector?

"We are an agricultural country, with 365 days of sunshine," says AK Taneja of Shriram Pistons. "Biofuels can not only address our emissions and sustainability issues, they also hold immense promise for the participation and prosperity of the politically important farming sector."

Demand for alternative fuels in the coming period is likely to be determined by the price and availability of different fuel categories, and the enforcement of new emission controls.

Demand pressure is likely to keep the price of conventional fossil fuels relatively high: the Economist Intelligence Unit (EIU) currently forecasts that global petroleum demand will grow at an annual 2.3 per cent over the next five years with most of the demand growth coming from Asia: Asian demand is forecast to grow at 6.1 per cent and Indian demand to grow at 7.2 per cent. The EIU also predicts that crude oil prices will fall moderately over the next five years, predicting an oil price of USD 44 per barrel by 2011. Such a price will increase the likelihood that only the most efficient producers of bio-fuels will find profit opportunities in the medium term. (Figure 18)

 
At current prices, however, existing alternative fuels offer a very significant price advantage where they are available. KPMG in India estimates that fuel costs for the average Indian passenger car are USD 9.8 cents per mile for conventional gasoline, whereas Liquid Petroleum Gas (LPG) costs USD 5.8 cents per mile and Compressed Natural Gas (CNG) USD 2.8 cents per mile.

India is currently experimenting with a range of alternative fuels. In both Delhi and Mumbai, CNG is already widely used for buses, taxis and three-wheelers. Some larger gas-powered vehicles run on LPG, although the distribution infrastructure remains embryonic. There are only two cross-country pipelines, both in Northeastern India, while one more is proposed. Some states have introduced gasoline blended with 5 per cent ethanol derived primarily from molasses, and field trials are underway on a 10 per cent ethanol blend. Bio-diesel which can be derived from a wide range of fat-bearing agricultural products (in India the crop of choice is the Jatropha plant) or even industrial waste is also limited to field trials in passenger cars, buses and trains. A very small number of electrically powered vehicles also operate.

Some companies believe that bio-fuels will emerge as a significant sector in the Indian economy, as policymakers grasp their potential for bringing new profitability to agriculture. "There is a big question in India over how farmers can participate in fast economic growth," says AK Taneja of Shriram Pistons. "The answer is bio-fuel."

Regulatory changes in India will also create demand for lower-emission alternative fuels. Under the Indian government's Automotive Fuel Policy, a series of new emission controls known as the Bharat Stage norms - standards modeled on European emission rules - are already being enforced in a rolling program ending in April 2010. The Bharat norms have already resulted in the conversion of all three-wheelers and taxis, in the national capital region (NCR) and Mumbai, to LPG or CNG vehicles; the phased conversion of diesel-based commuter public buses in target cities to CNG and the phasing out of commercial vehicles above 15 years in age.

Based on a survey of auto industry professionals, KPMG in India estimates that of the 14 'select' cities with access to piped fuel gas, approximately 10 per cent of passenger cars (or 680,000 vehicles) will be running on CNG by 2015. Commuter vehicles and light commercial vehicles are likely to be running on LPG and CNG without exception by 2015. As the final Bharat stage IV emission controls are introduced, a likely total of 2.17 million vehicles will be running on gas fuel in the 14 cities.

There is disagreement among companies over how readily consumers will adopt new fuels. Shriram Parameswaram of Eaton states "Historically India has always been a petrol market. Diesel was always seen as very down market - only recently have you seen a shift to diesel. And the 'right fuel, wrong fuel' mindset is still strong in India." But AK Taneja of Shriram Pistons points out: "Already all the buses and taxis in Delhi run on CNG - this is the largest fleet of buses in the world. This change was something that was readily embraced by the government and the people, sol see no reason not to go further and adopt bio-fuels."

In our survey of executives from Indian and global auto companies a majority (45 per cent) agreed that national distribution infrastructure was the key to developing a mature alternative fuel market. Some 31 per cent also felt that government subsidies towards alternate fuels would be essential during the early development of a national market. (Figure 19)

 
In interviews companies identified three critical issues for alternative fuel development:

▪	Policy Support: "It depends a lot on government: will they come out with the fiscal policies that are needed to support it?" asks Suhas Kadlaskar of DaimlerChrysler, commenting on the future of biofuels. He adds: "There is still a lot work to be done on processing this fuel: you have to be sure you can cultivate a suitable quality input, and you have to get sufficient yields. As a commercial reality it is at least five years away - we have yet to convince farmers that there is a profit in it" Sunil Rekhi of General Motors also doubts that new policies to support biofuel development will be in place soon. "Fossil fuel is coming to an end and the whole of mankind needs something to replace it I am not sure the government is really geared up to deal with this fact"
▪	Marketing: Companies believe that the consumer acceptability of alternative fuels for private vehicles remains untested. Shriram Parameswaram of Eaton believes that this is a market that has yet to materialize: "for one thing environmental consciousness is not widespread," he says. "There is a lack of demand, arising out of the reluctance to pay a premium for a higher cause."
▪	Infrastructure: Tata Motors says that there will be continuing constraints on the availability of gas fuels. Suhas Kadlaskar of DaimlerChrysler agrees: "To get the CNG infrastructure in place will take years. Today and tomorrow, petrol & diesel will be the fuels of choice."

 
Replacement of commercial vehicles will boom as older vehicles get scrapped and logistics hubs emerge

Most of India's commercial vehicle fleet is old and inefficient. Will a combination of new legislation and the development of more efficient distribution drive a new cycle of vehicle retirement and replacement?

"This is the need of the hour," says AK Taneja of Shriram Pistons. The commercial vehicle market is dominated by three companies (Tata Motors, Ashok Leyland and Mahindra & Mahindra) which account for nearly 90 per cent of the entire domestic commercial vehicles market Historically, commercial vehicles in India have tended to be short- to medium-haul vehicles, often owned by single-vehicle contractors. This is a result of poor federal infrastructure and an absence of organized retailing. Single vehicle contractors keep their vehicles for longer than larger logistics companies: almost a quarter of the commercial vehicles on India's roads are over 15 years old, while more than 40 per cent are over 10 years old.

"These older vehicles cause more pollution, they are more costly to maintain, and they cause more accidents," argues a senior executive of Endurance Group. "So we have to move to the concept of end of life for vehicles. The realization has come and I think the issue will gain momentum." Conversely, some companies believe that electoral sensitivities will slow progress: "You have to start vehicle retirement with commercial vehicles, but there are a lot of single vehicle owners out there, entirely dependent on their one vehicle," says Rajiv Dube of Tata Motors. "That is why the issue is sensitive." (Figure 20)

 
However, the commercial vehicle fleet is already changing fast Domestic sales of new commercial vehicles grew at 24.3 per cent for the whole segment over the last five years: medium and heavy vehicle sales grew at 23.2 per cent and sales of light commercial vehicles grew at 26.1 per cent (Figure 21). Sales have been driven by economic growth, easier financing, better roads and regulatory developments. In particular, a Supreme Court ruling in November 2005 sharply limited the permitted loading of commercial vehicles, creating replacement demand.

 
Growth is also being fuelled by new road building, including 5,800 km Golden Quadrilateral federal highway network that is now nearing completion. New roads and the increasing sophistication of retailing are leading to the emergence of a 'hub-and-spoke' national logistics network. This is likely to increase commercial vehicle demand, especially for vehicles at the larger and smaller ends of the spectrum.

Our survey of Indian and international auto executives revealed that there was almost equally strong support for the propositions that faster vehicle retirement and the emergence of logistics hubs as drivers of commercial vehicle sales. Some 34 per cent of respondents thought that vehicle retirement would create demand; 31 per cent felt that logistics hubs would do so.

"There is a perception change," believes Sunil Rekhi of GM India, who adds: "People used to buy a vehicle for a lifetime. Then they were thinking in terms of five years. Now it is three years. It is already getting harder and harder to run old vehicles. Insurers, for example, are getting very reluctant to insure vehicles that are over 15 years old."

In interviews, companies identified two critical issues for vehicle replacement:

▪	Policy Support: "The industry has been asking policymakers for a retirement policy for old vehicles," says Sunil Rekhi of General Motors. "The trouble is we are not getting it. Government is warming up to the idea, but as of today there is nothing actually on the table." Other companies agree that electoral sensitivity will determine policy: "That is why we think the starting point should be end of life regulations not for private vehicles but for example city bus fleets," says Suhas Kadlaskar of DaimlerChrysler. "Government understands that this is an area where they can use policy to influence safety and environmental standards. But measures should not be coercive, they should be incentive based." AK Taneja of Shriram Pistons says: "Government is not going to mandate an overnight change [in vehicle retirement policy]," he says. "It will be more like the approach to emissions. First there will be change in Delhi. Then the next biggest metro cities. Then the mini-metro areas. It is already happening – a truck or bus that is more than ten years old is not allowed to register or apply in Delhi. And this policy is something that will be gradually extended to other cities, virtually like a step-by-step vehicle retirement policy."
▪	Road Infrastructure: Prakash Kodlikeri of Kalyani Lemmerz believes that the next five years will see high commercial vehicle sales growth and renewal of fleets only if there are more improvements in road infrastructure. "Weak infrastructure is a real drag on growth," he says. "But there are huge efforts being made to improve that infrastructure. The whole program of highway building is delayed by around 1-2 years, but it is getting completed."

 
Conclusion

India's leading automotive executives are optimistic. That is the overall result of the interviews and surveys conducted for this report: several years of strong domestic growth combined with a growing level of internationalization of the manufacturing economy has given corporate executives high expectations for the near future.

Almost all the companies surveyed expect the above trend growth in the automotive sector to continue, fuelled by rising disposable incomes and increasing consumerism. They also believe that global automakers will continue to allocate a rising proportion of their foreign direct investment into India, growing auto manufacturing first and later auto engineering and R&D services.

Many companies are aware that their labor cost advantage is beginning to erode as both shop floor and managerial wage costs rise. However, they are optimistic that productivity improvements through low-cost automation and improved management efficiency will compensate for rising direct wage costs.

But Indian companies are also cautious. Their leading concern is the continuing cost imposed by India's relatively poor physical infrastructure, and the slow pace of improvement in road, rail and port facilities. They are also aware that the automotive industry lags behind other sectors such as IT and financial services in management training, reward and retention.

In international business, many companies surveyed speak of the need for more extensive alliances in distribution and marketing, and for more well chosen acquisitions especially in the auto component sector. Above all, Indian companies recognize that to achieve global scale they will need to meet the challenge of building persuasive global brands.

Nevertheless, the overall impression of these discussions is that India's auto sector has passed a critical turning point. The inherent strengths of India's manufacturing economy - an exceptional human resource base, the capacity to deliver high quality engineering products, and the strategic geographical positioning - have been reinforced by a strong domestic economy and a new readiness on the part of global auto manufacturers to make key investments in India.

The opportunity for India's automotive companies to emerge as leading participants in the global industry is clearly present: the challenge is no longer to create the opportunity, but to manage it.