It may once have been symbolised by the sturdy but decidedly dowdy Fiat 124 saloon-based Lada Riva, but Russia's auto industry has seen some modernisation in recent years. Inward investment from the global automotive industry has finally arrived. Local market conditions have also improved as the economy has picked up and carmakers have reported brisk sales. But recent events in the political arena have brought renewed nervousness and sent the stock market down. We review the current state of Russia's economy, vehicle market and industry.

Underlying macro worries
'Just when things had finally started to pick up and international investors appeared to have shaken off some pretty long-standing and negative attitudes to Russia, we get this. We can really do without it.' Those are the words of an investment banker in Moscow that we spoke to last week. His frustration is borne of President Putin's apparent decision to clip the wings of Russia's so-called business 'oligarchs' who made vast personal fortunes during the period of public utilities privatisations under former president Boris 'I'm just going for a nap' Yeltsin.

The problem is that the business empires formed by the oligarchs account for a substantial slice of private sector activity in Russia. Therefore an attack on them highlights some uncomfortable issues associated with the long-term condition of the Russian economy and the lack of progress in economic reform. This last point is crucial. International investors worry about the risks that investing in Russia carry. The risks are still difficult to quantify, even though many multinational corporations have decided over the past five years that the economic and political environment was at least moving in the right direction and some investment was therefore justified.

In reassuring international investors much depends on the messages sent out to the business community by President Putin. Lately, the messages emanating from the Kremlin have been less than clear about where the limits of the current attack on the oligarchs and - more importantly - their business empires may lie. That uncertainty has already sent the stock market down and dented confidence.

Unsurprisingly, the arrest of Mikhail Khodorkovsky, Russia's richest businessman, followed by the government's seizure of 44% of the shares of Yukos, the big oil company he managed before being locked away, weighs heavily on investors' minds. Jailing Mr Khodorkovsky is one thing. He'd apparently stepped out of line and breached an unspoken agreement with Putin that the oligarchs could keep their empires provided they kept out of the political arena. But what about the vast energy company he controlled? Could it lose licenses or face punitive charges? And will other big companies be forced to pay additional taxes/charges in order to maintain their positions and keep the government off their backs? Ultimately, will the role of regulation or state ownership in Russia be re-invigorated, to the detriment of the fledgling private sector?

Mr Putin is keen to reassure the big investment banks active in Russia that he remains committed to the free market. But memories are short. Only five years have passed since Russia's massive default left a clutch of western banks burnt and out of pocket. But the optimists point out that the economy is stronger than it was in 1998 and that it enjoys huge current-account and fiscal surpluses. And they also point out that Mr Putin has embarked on much-needed tax reforms.

But Russia is competing in a tough international market for capital. Countries to its west - such as Poland - are getting economically closer to western Europe. Industries such as automotive are investing heavily in Asia. Foreign Direct Investment (FDI) into Russia is mostly in natural resources rather than manufacturing industry.

Expect investors - including in the automotive industry - to look nervously at Russia over the next six months. Putin looks determined, for political reasons, to continue the assault on the oligarchs' business empires in Russia. The big question marks concern the manner in which this is conducted and its knock-on effects - both economic and political. Talking up Russia to steady nerves and avoid panic may be fine for now, but if the economy worsens and confidence collapses, international faith in Mr Putin to carry through the difficult process of reforming Russia's economy will start to dissipate. Investments in Russia could then start to look like bad investments.

Russia's economy gets energy boost
Since the devaluation of 1998, high oil prices and a big boost in oil output have helped the beleaguered Russian economy recover. Russia's treasury is reportedly so cash-rich that even if oil prices fell to $10 a barrel, the central government could end the year with its books in balance.

However, economists are expressing concern that while oil prices are relatively high there is little pressure to develop other parts of the economy. Thus, according to the World Bank, from 2001 to 2002 growth accelerated in the industries that export natural resources but slowed in those that produce goods for the home market. Moreover, small and medium-sized businesses grew more slowly than the overall economy.

Fixed investment in 2002 grew more slowly than the year before - seen as an ominous sign given the dire need to modernise dilapidated factories, equipment and public services. Some economists reckon that fixed investment in new plant and capital should be around 11% of GDP a year; the current rate in Russia is just 6% - far too little to sustain a real recovery in the long-term. And foreign direct investment into Russia is also still low.

But these structural worries aside, private consumption has been lively enough to promote rising purchases of consumer goods, including cars. Economic performance has been strong in the first part of 2003 - real GDP growth was estimated by JP Morgan at 8% in the third quarter. We expect performance to weaken over the remainder of the year, with real GDP growth of 5% for the year as a whole. Much depends on oil prices.

Russia has good automotive demand growth prospects
Demand prospects look very positive in Russia in the medium and long term, provided the economy continues to grow and incomes rise. Car ownership levels in Russia are low and Russia is a country that - in population density and land use terms - ought to be able to absorb a lot of cars. One risk is that the government may move towards adopting an excessively protectionist stance towards the automotive industry and snuff out imports. While the government has moved towards favouring more protection - higher tariffs - over the past year, we believe that the government's WTO ambitions will act as a major constraint.

New car sales in Russia are estimated at 1,050,000 units in 2002 - approximately 2% ahead of the previous year. The recent growth of car sales in Russia has been driven by rising real incomes and plenty of new model activity - especially from import brands. The market is dominated by products from local producers, most notably AvtoVAZ and GAZ, who have a combined market share of around 85%. However, imports are growing as Russian consumers are attracted to more modern and reliable products - albeit more expensive to purchase. Local producers have had to trim output at times over the past year as stocks have ballooned.

Medium-term market growth in Russia will be driven by growing disposable incomes, the development of consumer financing and rising replacement demand as consumers increasingly look to renew their ancient locally made models. Per capita car ownership is still low in Russia, but will be heading towards 200 cars per thousand by 2008. The Russian car market is expected to be heading towards 1.5 million units per annum by 2008.

While we expect the local producers share of the market to continue to be under pressure, we also believe that domestic makes will continue to dominate the market through 2008. The main reason for that is that local producers' vehicles will remain considerably cheaper to purchase and maintain than imported cars. AvtoVAZ models typically retail at around $4,000 against more than $10,000 for a western brand vehicle.

Protectionist noises sometimes heard
Last year, Russian carmakers appealed to the government for help and won some protective tariff barriers on imports. On average, new foreign cars now face a 25% duty, while tariffs on old second-hand imports are set at 35%. The import challenge posed to them is considerable. On average, sales of new foreign cars increased by 40% in 2002. Competitive credit has enabled the growing import presence. Before Ford launched production of the Focus last summer near St. Petersburg, less than 10% of its customers used credit to finance purchases, a figure that has now grown to 25%. That figure has a lot of upward mobility too - in Europe the vast majority of new car purchases are credit financed.

Toyota boosted its car sales in Russia by 111% in 2002 to over 8,300 units and much of its gain is attributed to a credit programme it has been running with Raiffeisenbank, a leading credit lender.

The foreign car brand sales leader in Russia is Daewoo, with vehicles produced at a plant in Uzbekistan. The Uzbek plant has reached an agreement with Daewoo's new owner (GMDAT) and signed a contract with the new brand owner for at least three years; through that they have secured access to kits for assembly and retained exclusive distribution rights in Russia.

Russia: new car import sales by brand - 2001, 2002
Brand
2001
2002
%ch
Daewoo
10,000
12,418
24.2
Skoda
8,391
9,407
12.1
Renault
5,606
8,337
48.7
Toyota
3,928
8,302
111.4
Mitsubishi
6,004
8,167
36.0
Nissan
5,286
8,029
51.9
Volkswagen
7,254
7,972
9.9
Peugeot
4,246
6,984
64.5
Ford
4,124
6,669
61.7
Hyundai
2,205
5,575
152.8
Kia
3,727
5,379
44.3
BMW
2,636
3,790
43.8
Volvo
2,402
2,929
21.9
Opel
1,458
2,867
96.6
Audi
2,508
2,700
7.7
Mercedes
3,806
2,441
35.9
Citroen
1,009
2,272
125.2
Suzuki
1,220
1,912
56.7
Honda
837
1,340
60.1
Land Rover
410
839
104.6
Chrysler
134
380
183.6
Fiat
618
356
42.4
Lexus
154
328
113.0
Chevrolet
544
275
49.4
Saab
144
199
38.2
Total
78,651
109,867
39.7
Source: COMMERSANT

How will the structure of Russia's car industry change?
The big question facing the Russian car industry and market is how it may restructure and modernise in the future. AvtoVAZ has made it clear that it is looking for a strategic partner to help it to modernise and become more competitive. GM has a JV with AvtoVAZ (Chevy Niva) and could conceivably step up its involvement in the future, but GM's management is likely to be wary.

But Western firms may look to acquire Russian automotive companies or conclude more joint ventures in order to gain access to the Russian market and circumvent any restrictions on built-up imports. The level of foreign direct investment (FDI) in the industry is still very low. Local production by Western brands is still low, but will be rising. The GM-AvtoVAZ Chevrolet Niva is being prepared for export production and Ford is planning to increase output at its plant.

Volkswagen and Toyota eye Russian investment
Russia's current political uncertainties come at an interesting time for the auto industry. Volkswagen and Toyota are circling and said to be seriously considering following Ford and GM (and, coming up from the blind side, Kia) by investing in manufacturing facilities Russia. The big advantage in setting up a manufacturing facility in Russia is the tariff gain which means that cars can be sold on the Russian market at a much lower price than imported models.

Volkswagen admitted recently that it is in discussion with the Russian government about the conditions under which it could set up a car factory in the country. The company is said to be hopeful of a result and decision by the spring of next year. Volkswagen has told the Russian government that it will only invest if restrictions limiting imports of parts after three years are lifted. Details of Volkswagen's possible entry strategy are unclear, but sources indicate that a low-volume operation making VW-branded cars from assembled CKD kits would be most likely in the beginning.

Toyota is also keen not to be left behind in Russia. A high-level delegation from Toyota recently visited Nizhny Novgorod, the hub of Russia's car industry in the Volga River region, to exchange views with Russian officials on Toyota's possible car production in Russia. A tie-up with a Russian car manufacturer has not been ruled out.

Toyota is reported to have a number of production plans for Russia, including one to turn out tens of thousands of the Corolla small passenger car and the Land Cruiser sport-utility vehicle every year. Toyota earlier planned to launch the production of commercial vehicles in Russia in 1999 but shelved the plan as a result of the country's economic crisis and political instability. Toyota is said to be aiming to start production in three to four years' time. A feasibility study is underway and it is also rumoured said that a Russian plant may be used by Toyota as a manufacturing base for increased shipments to Europe.

The company is aiming to sell 20,000 Land Cruisers a year in Russia by 2008.

Fiat is also said to be ready to ink a deal to sell cars and trucks in the Russian market through an alliance with a local partner. Manufacturing in Russia is a long way off though.

Kia ups investment
Kia Motors Corporation has signed a new agreement with Russian car manufacturer Izhmash-Auto to begin production of the Kia Spectra (the Shuma in some markets) four-door saloon from November 2004.

Kia will supply the cars to Izhmash-Auto in CKD kit form and the Russian company is planning to assemble 1,000 cars in 2004 and 40,000 during 2005 at its existing plant in Izhevsk, the capital of the Udmurtia Republic, 1,300 km east of Moscow. By 2007, annual production is planned to reach 120,000 cars.

KMC will assist Izhmash-Auto with the upgrading of its facilities and with technical training for its assembly workers and engineers. Production of the Spectra will include manufacture of the engine and transmission, using equipment supplied by KMC.

The new agreement with Izhmash-Auto does not effect Kia's continuing relationship with the Russian vehicle manufacturer Avtotor. The company assembles the Kia Sportage model at its plant in Kaliningrad, on the Baltic coast, 1,200 kms west of Moscow, which has a capacity of 10,000 cars per year.

GM-Avtovaz moves to three-shift working and adds Astra
The GM-AvtoVAZ joint venture plans to switch to a three-shift working pattern from autumn 2003 as production for export markets is ramped up. GM and leading Russian car producer AvtoVAZ each have a 41.5% stake in GM-AvtoVAZ, while the remaining 17% stake is owned by the European Bank for Reconstruction and Development (EBRD).

The joint venture currently produces Chevrolet-Niva SUVs and plans to produce more than 36,000 cars this year. GM-AvtoVAZ started operating in September 2002.

It has also recently been confirmed that the joint venture will add manufacture of the Opel Astra (last generation model, sedan variant). GM-AvtoVAZ wants to start producing sedans of current Astra (code-named T3000) in early 2004 with annual volumes forecast to reach 10,000 in 2004 and 25,000 in 2005-2008. Models will be badged Chevrolet and sold only in Russia. It is thought that the model will be priced to target the locally-made Ford Focus.

Ford's Russian output up this year
Ford increased Russian sales of its Ford Focus by 415% to 9,412 cars in the first nine months of this year. Sales of all models available in Russia rose 218% to 12,841 during the same period. The Ford Focus is the best selling non-Russian model on the market. Ford started to make the Focus family saloon outside Russia's second city, St Petersburg, in July 2002 and plans to make between 12,000-15,000 cars this year.

Ford expects to sell 18,000 cars in Russia in total this year, which would give it over 1% of the market - Ford wants 10% by 2010.