Full speed ahead: Despite the economic slowdown the long-term future of Mexico's auto sector looks bright--as long as it can adapt to further liberalization of the regional market.

Despite recession clouds, analysts say the future is bright for the nation's prospering automotive sector, so long as producers can adapt to the competitive challenges posed by the elimination of Mexico's Auto Decree on Jan. 1, 2004, which regulates the origin of components.

Between 1990 and 2000, the automotive sector attracted 26% of all foreign direct investment into Mexico, and the imminent formation of a fully integrated Nafta marketplace, has spurred auto makers to invest US$15 billion over the last six years.

Mexico's key vehicle assemblers--DaimlerChrysler, Ford, General Motors, Nissan and Volkswagen--have focused on export production, mostly to the United States. The top exports range from unique niche vehicles (DaimlerChrysler PT Cruiser and VW New Beetle) to compact cars (Nissan Sentra and Ford Focus/Escort), to sports utility vehicles (GM Suburban) and pickups (DaimlerChrysler Ram 1500/2500 series).

Automotive goods are the nation's largest export, generating more foreign exchange than oil or tourism. New plants and modernization have helped raise productivity dramatically in the past nine years, analysts say. Only in the past three years have wage gains begun to outstrip productivity improvements. That's why business leaders' complaints about the recent pay settlement at Volkswagen's Puebla factory had a dissonant ring to them, according to Guillermo Valdes, a political scientist at the Economists Associates Group (GEA) in Mexico City.

STRIKE FALLOUT

The 19-day strike at the German automaker's only Mexico plant won the 12,300 union workers a 14.7% increase in their overall pay package, well above Banco de Mexico's 6.5% inflation goal for 2001.

Raul Picard, president of the nation's manufacturers' chamber (Canacintra), warned local newspapers the pay hike could create inflationary trouble. "It was a terrible deal and will influence the next round of salary negotiations, causing Mexican companies to lose competitiveness," he said.

Valdes thinks differently.

"Most wages haven't recovered 1994 levels, so it's an exaggeration to think they (the union s demands) are high," he says. "This type of strike has arisen in many other countries and investors shouldn't make generalizations from it. You can't say it is a frightening signal."

Before the stoppage, workers at the plant typically earned US$25.50 a day. In addition to coupons for food and children's supplies; the new contract raises average pay to US$28.50 a day. By contrast, pay for union auto assembly workers in the United States ranges from US$120 to US$190 for an eight-hour day.

On Sept. 6, the day after the strike ended, Volkswagen de Mexico spokesman Thomas Karig told BUSINESS MEXICO: "This second strike in two years diminishes our competitiveness within the group. We are rethinking under what conditions investment can be continued in Mexico."

Volkswagen plants in Brazil and China are alternative suppliers of their Golf and Jetta models to Canadian and U.S. markets. "We mustn't think we are the natural source for cars for North America," says Karig.

At risk, if Volkswagen freezes expansion plans at Puebla, could be US$1 billion in capital spending over the next five years to prepare for new models. An announcement will be made at the end of October when budget decisions are finalized at the company's Germany headquarters.

Production of the convertible version of the New Beetle, whose roofed counterpart was a cult hit in the United States, won't be affected; the car will begin rolling off assembly lines in spring 2002.

"It's a show of bravado," says Humberto Juarez Nunez, a professor of labor relations at the Autonomous University of Puebla, of Volkswagen's threat. "We saw similar intimidation from management after the 1984, 1987, 1991 and 1992 disputes."

Any company is going to think twice about moving from the plant in Puebla, about 100 km east of Mexico City, he says. "The infrastructure in the state is adequate, workers are highly qualified and experienced; there are high learning costs associated with setting up elsewhere."

That's not to say workers should rest on their laurels. "Unions are going to have to evolve and take a different focus," says Armando Soto, who tracks the nation's car industry for the Ciemex-Wefa economic consultancy in Mexico City. Workers will have to get used to pay hikes closer to one digit. From 2000 to 2004, Soto expects real wages will rise 33%, while productivity will increase only 9%.

Economist Rogelio Ramirez de la O agrees. "It's no longer an easy answer to produce cars in Mexico," he says, noting that labor costs in the industry have risen 50% in dollar terms since the end of 1998.

Output per head is about a quarter of what is achieved in the United States according to Sean McAlinden, a University of Michigan analyst. "Given cooked and tested technology and fairly simple production lines, Mexico can match U.S. productivity rates for some vehicles," he says.

This year's news, as documented by The New York Times, was that the company reached a settlement without the strike being stopped by the government. Under the 71-year rule of the Institutional Revolutionary Party, labor and party officials worked in concert. Once the ruling party brokered a consensus, the government would enforce it, by breaking up the strike if necessary. But in the Volkswagen strike, Labor Secretary Carlos Abascal did not enter negotiations until the final days. Analysts were left wondering what leverage President Vicente Fox's government is willing or able to exercise in future disputes.

NEW GIANT IN MEXICO

If No.1 Japanese automaker Toyota Motor Corp. is worried about labor relations, it is keeping these concerns to itself. Toyota has made strong hints that it is leaning toward Mexico as the location for its fifth assembly plant in North America and is pushing to sell two million vehicles a year in the United States by 2006. Come 2004, the terms of Nafta will eliminate a 1989 Auto Decree requiring automakers to build a certain quantity of Mexican parts into their vehicles. The decree is the culmination of a 10-year phase out of the local content and trade-balancing requirements designed to prevent a trade deficit in the domestic auto parts industry.

Toyota plans to begin selling vehicles in Mexico in spring 2002. At the end of the transition period, the provisions of the Investment and Market Access chapters of Nafta will govern production and trade in the automotive sector, and Toyota will be free to source auto parts from any supplier in Canada, Mexico and the United States and can tap import and export markets in North America unimpeded by trade restrictions.

The company had withdrawn from its arrangements with third-party assembly plants in the mid-1960s because it "didn't like the politics of importing cars and parts from Mexico into the United States given the sensitivity regarding U.S.-Japanese trade relations," says McAlinden. Nor did Toyota trust the workforce and economic infrastructure. It found low levels of education, no English-language speakers, high turnover rates, unreliable support services and abundant corruption. Those concerns have diminished, he says.

Officially though, the company has made no decision about a Mexico plant. "In general, Toyota's approach to new markets is to establish sales and evaluate the market first and then consider possible local production. Otherwise it would be putting the cart before the horse," says Mike Michels, national media relations manager with Toyota Motor Sales, USA.

Mexican Automobile Industry Association (AMIA) figures for the first half of 2001 show domestic sales bearing up remarkably well even as U.S. demand slumps. New car sales rose 16.4% in the January to June period compared to the same six months the previous year, although sales in the light and heavy tuck segments fell 2.9% and 9.36% respectively. Total vehicle sales grew 9.7% in the first half of 2001, as the strong peso attracted imports.

Vehicle exports and production slowed sharply in July compared to the month earlier as the U.S. slowdown began to bite. Nevertheless, output of cars and trucks is expected to increase 29% by 2004 to 2.27 million vehicles annually, with two-thirds destined for export, says Ciemex-Wefa's Soto.

START YOUR ENGINES

Conscious that Mexico possesses a potentially large domestic market and has access to a huge export market, Toyota's top Japanese rival Nissan Motor Co. plans to raise total output by 30% by March 2004. It will increase production of Sentra sedans for the U.S. market and start making Clio subcompacts for France's Renault S.A. by year end. The second-largest automaker in Mexico with a 20% market share, Nissan aims to raise Mexico sales by 9.8% to 190,000 units in 2002.

And that's only one company with high growth expectations. For Kathleen Ligocki, who became Ford Motor Co.'s Vice President of Canada, Mexico and North American Strategy, on Aug. 1, the challenge is to market Ford to Mexico's youthful middle class. Ligocki is reshaping the company's lineup by importing the Fiesta from Britain, the Ka and the Fiesta Courier from Brazil, and assembling the Ikon in Mexico. The cars are aimed at the entry-level consumer.

The local subsidiary of the world's No. 1 automaker sees the slowdown as a period of consolidation. General Motors de Mexico President Arturo Elias said the company is devoting time to dealers and suppliers to ensure that a strategy is in place for the economic recovery in Mexico and the United States, which it expects will be noticeable in the fourth quarter. This recovery, however, will not be strong enough to reverse poor North American results in 2001.

INDUSTRY PROSPECTS

Bearing the brunt of the downturn is the auto-parts industry, which sends up to 90% of its output to the United States. Mexican auto-parts manufacturers Desc S.A., Alfa S.A., Vitro S.A., Grupo Industrial Saltillo S.A. and Corporacion San Luis have cut jobs or canceled production lines as sales fell 12% in the first half compared to the year-ago period. Despite the near-term blues, analysts expect auto-parts exports to be fastest on the rebound aided by some canny export strategies. San Luis, for example, has invested about US$500 million in new factories and has set up a technology and design center in Plymouth, Michigan, to coordinate production with its Detroit customers.

As the economy picks up, analysts expect the reactivation of credit to raise sales. Banks extended 30% more auto loans in the first six months of 2001 than they did in the same period of 2000, with Banamex, BBVA-Bancomer, Scotiabank Inverlat, Bital and Citibank leading the way. "Any person earning 10,000 pesos (US$1,100) a month can now buy a car," says Ciemex-Wefa's Soto.

With the 2002 new model season approaching, automakers' own financing arms are offering tempting deals on 2001 model autos. Ford and DaimlerChrysler are offering 24-month financing with a 30% down payment on most models (Lincoln, Jaguar and Volvo are among the exceptions). Similarly, Nissan has lowered financing rates on all but the top-of-the-range models. A reduction in sales taxes (currently more than 30% of the price of a new car) could be the extra shot in the arm the domestic market needs, says AMIA. Although tax cuts could partially ease the problem of illegally imported, pre-owned autos by reducing the price gap between new and used vehicles, they were not included in the Fox government's fiscal reform proposals:

As for the future under Nafta, Ciemex-Wefa sees the sector's trade balance shifting from 52% imports/48% exports in 2001 to 70% imports/30% exports by 2006. Gradual liberalization has allowed the auto industry to adapt by keeping some import restrictions and by giving domestic producers access to an enlarged regional market. When new-car import quotas, domestic content requirements and restrictions on foreign investment in auto-parts manufacturers are eliminated in 2004, regional competition will be fierce. Mexican auto-parts producers in particular will be forced to turn to higher value-added goods. Hence federal and state authorities need to collaborate to improve infrastructure and encourage technical education in the short time that remains, says AMIA President Cesar Flores.

If Mexico can do this, the future looks so bright the industry will have to invest heavily in tinted glass.

Andrew Watson is a financial reporter and editor at a Mexico City daily.