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The auto industry in Latin America: the challenge of adjusting to economic reform.

WHILE HEADLINES focus on the rapid collapse of the centrally planned economies, the Latin American countries proceed on their own fast march toward liberalizing their economies. This march is already forcing rapid adjustments by the traditional players in these markets. It will drastically change the nature of the auto industry in the region during the next decade.

In order better to understand the upcoming changes in the Latin American auto industry, it is essential to analyze the key elements of the structural changes that transform the Latin American economies from a state-controlled into a free-market system.

STRUCTURAL REFORMS

Today almost all the major economies in Latin America, with the possible exception of Brazil, have aggressively moved away from the import substitution and state-controlled development model that prevailed since the 1940s. Chile was the first coun| try to attempt such a move in the late 1970s, under the Pinochet regime. Although some of the elements of economic reform were not implemented until 1984. Bolivia followed the Chilean example in 1985, after more than two years of hyperinflation. Yet, annual inflation still remains above 20 percent in Chile. In Bolivia, while annual inflation is in the one-digit level, privatization is still to come.

It was not until the Mexican experience in 1988 that the key elements of success were defined and the sequencing of implementation clearly identified. Subsequently, Argentina in 1989, Venezuela in 1990 and Colombia in 1991 also took decisive steps toward liberalizing their economies. Brazil, the largest economy in the area, is still dragging along and finding many (mostly political) difficulties in adopting the process. It is not coincidental that in all cases except Chile the decisive steps were taken as a last policy alternative. The steps were to end a recession produced either by the 1982 debt crisis directly, or by the 1983-86 adjustment policies, or to end hyperinflation of Bolivia in 1985 and Argentina in 1989. The key elements of reform in each of these countries, and how the auto industry will have to adjust to such reforms are interesting.

MEXICO: A FAST AND SIMULTANEOUS PROCESS

The Mexican experience is perhaps the clearest example to identify the key factors contributing to quick success. In 1988 Mexico began its economic restructuring by focusing simultaneously on four interrelated issues: price stabilization, privatization, domestic deregulation and trade liberalization.

The price stabilization process was buttressed through a series of social pacts. The first was announced in December 1987, when annual inflation was 160 percent. Mexico's policymakers recognized that without stabilizing the public sector's budget it would be impossible to implement a responsible monetary policy. Price stabilization would not have lasted longer than the failed experiences of the Austral (Argentina, 1985) and the Cruzado (Brazil, 1986) plans. The control of the public deficit was achieved through both the revenue and the expenditure sides. On the revenue side, tax reform was implemented broadening the tax base and simplifying the tax structure, and the laws were rigorously enforced. On the expenditure side, major cuts in public sector investment were implemented, all subsidies were eliminated (including gasoline subsidies, in spite of Mexico's oil richness) and an agressive privatization program was immediately begun.

By 1991 only 212 firms remained in the public sector out of the 1156 that existed in 1982. More importantly, while most of these firms were sold to private investors (domestic and foreign), many were simply closed, in spite of the high political cost of higher unemployment. Many organizations that had been set up within the public bureaucracy to oversee public companies were eliminated, "leaning up" the administration.

The third element of economic reform was domestic deregulation. The best example in this area is that of the trucking industry, which until recently had legislation requiring trucks to go empty one way. The new auto decree (1990) still contains significant restrictions incompatible with flee-market policies (e.g., domestic value added and balance of trade requirements), but it lifted the requirements that limited the number of models to be produced by a company or established the specific components to be produced in Mexico. The significant relaxation of the foreign investment law (1990) now permits, under certain conditions, up to 100 percent foreign ownership, as another example of deregulation.

The forth key element of economic reform in Mexico was trade liberalization. Until the mid1980s Mexico was one of the most closed economies in the world. In 1982 more than 95 percent of the products imported were subject to licenses, the maximum tariff was 100 percent and importation of many products was banned or subject to quotas. In 1991 fewer than 5 percent of imports required license, the maximum tariff was 20 percent and only chemicals and automobiles retained quotas. Establishing a Free Trade Agreement with the United States and Canada will be key to lock these measures in place and ensure that future administrations do not reverse this process.

Fast and simultaneous privatization, liberalization and deregulation also contributed to the stabilization process, thus feeding back into a virtuous cycle, reducing the uncertainties that existed before 1988. An additional element contributed somewhat to reducing uncertainties: the 1990 renegotiation of foreign debt under the Brady plan. It must be noted, however, that such agreement was not reached until after many of the restructuring measures were well under way. Moreover, the effective debt reduction accomplished in that package was not very large, slightly less than 1 percent of GDP. But reaching agreement with the commercial banks was key in reducing the uncertainties on debt payments and in restoring the confidence of the international financial community.

Speed ofimplementation, across the board policy consistency, and continuity of the policies gnaranteed Mexico's quick success: (a) Without price controls inflation is less than 18 percent per year versus 160 percent in 1988; (b) without exchange controls the currency is stable and the level of international reserves very high; (c) the restoration of confidence has led to massive capital repatriation; (d) the public deficit is basically balanced and monetary and fiscal policies are still cautious; (e) the public sector is focusing only on traditional public functions (education, public health, low income housing, even only a minimum of infrastructure); and, most importantly (f) economic growth is fully led by the private sector.

Ironically, all these reforms, which aim at converting the economy from state-controlled to a free market, would not have been possible without a strong government, as sometimes they carried a high political cost. It is not a coincidence that only Chile had accomplished a similar restructuring before.

CHILE: A SEQUENTIAL EXPERIENCE

In Chile's case, the structural reforms were implemented more sequentially than in Mexico. Chile accomplished some price stabilization by drastically opening the market in 1975, and later fixing the exchange rate in 1979. As a result, most of the domestic industry collapsed overnight (real GDP dropped by 13 percent in 1975). By 1982, the grossly appreciated currency, combined with the lack of funds in the international markets and with the sharp decline in copper prices, produced a balance of payments crisis. This in turn led to very large devaluations of the Chilean peso (both in nominal and real terms) and to another steep recession (real GDP fell 14 percent in 1982).

The privatization and deregulation process did not begin in Chile until after the debt crisis of 1982. In fact, Chile was the first Latin American country to use debt swaps to reduce its foreign debt and, at the same time, to bring back foreign investors. It was this process, not the 1975-81 liberalization of the market and exchange rate appreciation, that led to the diversification of the Chilean economy out of its heavy dependence on copper. Nevertheless, the diversification was "back to basics:" agriculture (particularly fruits), forestry and fishing. Only recently has an incipient furniture industry begun to flourish. Moreover, inflation is still high for a "successful" case: in only two out of the past fifteen years has annual inflation in Chile been less than 20 percent. By contrast, in Mexico annual inflation has been less than 20 percent in two out of the past four years.

ARGENTINA: ALSO A FAST AND SIMULTANEOUS PROCESS

In Argentina the process of structural transformation was much more difficult. Ironically, it was carried out by a president (Carlos Saul Menem) belonging to the same Peronist Party that had been responsible for introducing "stateism" in the country in the 1940s and 1950s, and again from 1973 to 1976. But this process did not begin until after the country suffered the traumatic experience of hyperinflation (June-July 1989). Thus, newly elected President Menera had no other alternative but moving toward the free market policies his own party opposed.

Price stabilization was achieved, however, through a complete dollarization of the economy. This was possible because Argentines had accumulated massive amounts of capital abroad during the previous two decades (estimated at more than $50 billion). They were forced to repatriate much of this through a very tight monetary policy. Yet the stabilization of the fiscal budget was established as a high priority. In 1990 more than 160,000 public employees were laid off. In 1991 a tax reform was implemented, and, in a country where tax evasion was national pride, tax evaders are now severely persecuted, as in Mexico.

In early 1991, after many failed attempts, privatization hit full speed and now more than 50 percent of the public companies up for sale have been privatized. The complete opening of the market began in mid-1991, and by year-end the deregulation of domestic and external commerce had also began. As a result, in the last months of 1991, without price controls, consumer price inflation was around 1 percent a month for several consecutive months, and wholesale prices actually declined in two months -- a record not achieved in many decades. After reaching this price stabilization and with the exchange rate stable (in nominal terms), for almost a year, a new currency was introduced with a parity of 1 to 1 to the U.S. dollar. More significantly, industrial production is already rebounding.

VENEZUELA AND COLOMBIA: IN EARLY STAGES

In Venezuela another formerly populist president, Carlos Andres Perez, moved toward free market policies. A major adjustment of the exchange and financial markets took place in 1989 and resuited in an 8.6 percent decline in real GDP that year. The foreign debt was restructured in late 1990 under a Brady-style agreement. Unfortunately, the policymakers did not follow through immediately with all the elements of economic restructuring.

An aggressive privatization program was unnecessary in Venezuela, because outside the oil sector not many firms were owned by the public sector. The degree of subsidization was extremely high and spread to all sectors of the economy. Although many subsidies have now been lifted, a key one still remains. Even after last year's 100 percent increase, the cost of gasoline is the equivalent of twenty-five U.S. cents per gallon -- well below international prices. By the end of 1991 the public deficit was still high and monetary policy remained lax, raising doubts about the long-term viability of the stabilization process. Annual inflation is still above 30 percent annually. Trade liberalization has started with two rounds of tariff reductions, but deregulation of the domestic economy (aside from prices) has not taken off yet.

Neither does Colombia need a strong privatization program. Inflation has been relatively stable, with prices at wholesale levels growing between 20 and 30 percent annually for the past twenty years. But this is still exceedingly high for a "free market economy." The Colombian market remained highly protected in the past decades: the maximum import tariffs until 1990 were 200 percent, and a good number of products remained banned from importation. The policymakers took an aggressive step to open the markets in late 1990, and continued it under the December 1991 Andean Pack agreement. Now the maximum import tariff is 25 percent (40 percent only for autos) and by 1994 is scheduled to go down to 20 percent (25 percent for autos). In late 1990 the Colombian administration also implemented a very tight monetary policy, raising reserve requirements, for a limited time only, to 100 percent. In early 1992 a tax reform aimed at keeping the public budget in balance was under discussion.

BRAZIL: VERY SLOW PROGRESS

Brazil is the laggard in reforming its economy. President Collor's attempt to stabilize prices through a heterodox shock plan in March 1990 was not accompanied by the necessary parallel measures: immediate privatization, deregulation and liberalization. This delay is the result of a constitutionally weak power of the presidency for implementing economic policy, just the opposite of Mexico. Moreover, the politically and constitutionally powerful Congress, and the powerful state governments, are often directly linked to the large public enterprises that should be privatized.

In contrast to Bolivia and Argentina, Brazil did not go through a "true" hyperinflation process -- a situation where prices change by the hour -- thanks to its complex indexation system. Consequently, the urgency for changing the structure of the economy has not surfaced yet. Nevertheless, some changes are on the way. Delayed by many court battles and public opposition, the privatization process began in mid-1991 with two public companies. In late 1991 a tax reform was approved by Congress. The trade liberalization process and tariff reductions are already in place, although it is much less aggressive than in all the other Latin American countries. But inflation remains above 20 percent per month. And without price stabilization, the interrelated benefits of these tenuous moves will not be felt. Progress will be extremely slow -- if it occurs at all. Thus, Brazil may well take much longer to achieve structural change than Mexico and Argentina, although the potential for the country to do it faster does indeed exist.

In short, each one of these countries is at a different stage in reforming the structure of its economy. Chile and Mexico are well advanced. Argentina is moving very fast. Colombia has just started the process. Venezuela is moving very slowly. Brazil stands alone with serious constitutional difficulties in the way of reform implementation.

WHAT DOES THIS MEAN FOR THE AUTO INDUSTRY?

The auto industry in Latin America developed during the 1950s and 1960s, when the theory of import substitution reigned in the region. The major policy objective of import substitution was to satisfy the local market with local industry. The political objective was to increase employment, not to develop a world-competitive industry. As a result, these policies included large tax incentives and very high tariff and non'tariffbarriers, including, in most cases, outright banning the importation of cars. From a multinational viewpoint, participation in these markets was only possible through local production. That is basically why a local automotive industry developed in Argentina, Brazil, Chile, Ecuador, Colombia, Mexico, Uruguay and Venezuela.

In the rest of the countries in the continent, with mostly smaller markets and/or with a significantly lower income per capita income (during the 1950s and 1960s), the importation of vehicles was permitted. Consequently, it wasn't necessary to develop a local industry to participate in them.

As the traditionally Closed Latin markets continue to open, the local producers will be subject to intense competition and a demand for higher quality. Thus, the local producers receive pressures both in terms of price and quality -- the same pressures that American manufacturers have received from the Japanese since the 1970s. As in the U.S., these pressures will lead to the rationalization of local industry. This is an unavoidable process that the Latin American auto industry will have to adjust to during the next decade. Moreover, this rationalization will follow the on-going restructuring of the world auto industry that began in the past three decades and that is still taking place in North America.

THE "LEAN PRODUCTION" SYSTEM

Expansion of the Japanese automakers as world players during the past three decades has completely transformed the auto industry. James Womack and other researchers of MITs International Motor Vehicle Program have analyzed this transformation extensively. It encompasses all stages in the industry from the design and engineering of the vehicle, through the relationship with the suppliers and the production of the vehicle, to the marketing and aftersale relationship with the customer. Using auto-industry jargon, Womack et al. argue this system is a "lean production" process perfected by the Japanese in the 1970s, and drastically changed the "mass production" system that had been pioneered by the Americans at the beginning of this century.

This system is 'lean" because it uses about half of everything: the human effort, the development time, the capital and tools, the manufacturing space and the inventories of traditional mass production. It yields a wider variety of models with a third as many defects as in the average mass produced product. Moreover, lean producers live by the principle of continuous improvement, including continuously lower costs. Unfortunately, this description does not fit most of Latin America's auto industry, except, perhaps that of Mexico -- and even in Mexico, only in the past three years.

Rationalization is possible in the region, particularly within the limits of the sub-regional trading blocks that are quickly being formed: North America, the Southern Cone and the Andean Pact.

MEXICO UNDER NAFTA

Mexico's auto industry is already integrated into the North American market, and the implementation of a North American Free Trade Agreement, NAFTA (as of this writing, yet to be reached and approved by Congress) will only strengthen this integration. In preparation for the competition that free trade will bring, in the past three years the Mexican manufacturers have been improving quality and productivity by leaps and bounds.

Now that higher quality has been achieved, further rationalization is still possible. Savings from economies of scale and lower import prices can be passed on to consumers, demand should surge, continuing the fast growth of the Mexican market experienced in the past four years. Totals could reach 1 million units by the middle of the decade from 600,000 at present. Nevertheless, in spite of the improvements of the past four years, local manufacturers (GM, Ford, Chrysler, VW and Nissan) will still be subject to increased competition, particularly from the Japanese transplants in the U.S., or even from other parts of the world, in spite of the 20 percent external tariff for imports from outside the NAFTA.

ARGENTINA AND BRAZIL UNDER MERCOSUR

The second trade block where rationalization is possible and imminent is Argentina-Brazil, which signed an integration agreement in 1989 and are the core of the MERCOSUR market, which includes also Uruguay and Paraguay. Nine manufacturers are producing vehicles in Brazil and six in Argentina, with a combined capacity of over 1.5 million vehicles. They serve a combined market of around 1,000,000 vehicles, which has the potential to grow, under conditions of price stability in both countries, to over 1.5 million units by 1995. Thus, even under a conservative assumption that imports could take 15 percent of the market, capacity utilization would still be below 100 percent.

The agreement signed in March 1991 forming the MERCOSUR provides for full integration of trade between Argentina and Brazil (with no tariffs) by 1995, Uruguay and Paraguay would join a couple of years later. Protocol 21, which regulates trade for the auto industry, has approved programs for over $500 million in 1991 and for $1 billion in 1992, with no tariffs. Nearly 10,000 fully built vehicles were shipped in 1991 by Argentina and Brazil; in 1992 that limit might be increased to 18,000 (including 2,000 trucks). Autolatina (Ford-Volkswagen joint venture), GM, Renault, Fiat, Scania and Mercedes Benz are very active trading fully built vehicles, as well as rationalizing components. For example, Sevel is sending 1600cc engines to Fiat do Brasil, and Autolatina's new transmission plant in Argentina, with a capacity of 300,000 units annually, will supply Argentina, Brazil and possibly other markets.

Rationalization doesn't come without pain: in December 1990 Autolatina closed its Monte Chingolo plant in Argentina that used to build two VW models. Even so, Autolatina's capacity utilization in Argentina is still under 50 percent. The components industry in both countries, Brazil and Argentina, is also forming joint ventures to rationalize production. It is too early to see if this incipient rationalization will lead to reclassifying old plants as "lean producers."

Ironically, although the Brazilian industry is larger and, in principle, closer than Argentina's to obtaining economies of scale, it may have a slight disadvantage today, because Argentina is more advanced in the stabilization process. Macroecoonmic stability permits business planners to focus more on long-term investments and on improving the efficiency of the production process, rather than wasting resources and efforts in coping with high inflation. If the macroeconomic structural reforms do not take hold in Brazil, the Brazilian industry will find it difficult to compete with the Argentine.

THE ANDEAN PACT

The third trade block in rapid formation is the Andean Pact. In December 1991 the presidents of Bolivia, Colombia, Ecuador, Peru and Venezuela agreed to form a customs union with zero tariffs beginning in January 1992 (July 1992 for Ecuador and Peru). The combined Andean Pact vehicle market is roughly 150,000 units. There are thirteen assemblers in Venezuela, three in Colombia, three in Ecuador and eight in Peru (some assembling fewer than 100 vehicles a year!) with a total capacity to assemble 300,000 units.

Clearly it is in this region where opportunities for rationalization are large.

No tariffs among these countries would make it possible to reduce the number of models assembled in each plant and ship them to the other countries in the region. Even so, with maximum external tariff of 25 percent by 1994 (for fully built vehides) the pressure from imports will be intense in a combined market which, at best, could grow to 250,000 units by 1995-96. So, even under a conservative assumption of imports taking 15 percent of the market, capacity utilization would still remain under 80 percent. Local assemblers will also be able to iraport vehicles to complement their product portfolio. This practice will fragment the market even more, thus increasing the competitive pressures, just as occurred in Chile.

Chile and Uruguay also assemble vehicles in the region. In Chile only two assemblers remain, GM and Franco Chilena (Renault-Peugeot), serving perhaps one of the most competitive markets in the world. More than 30 nameplates and 200 models are offered in a market of 70,000 units. The local industry today assembles less than 17 percent of domestic sales versus nearly 30 percent in 1980. It receives no protection from fully built imports (15 percent is the import tariff for both fully built vehicles and CKDs, "knocked down kits"). There are only marginal trade balancing benefits that are due to expire in 1995. Ten assemblers in Uruguay serve a market of 14,000 vehicles! The prospects of these assemblers to survive the Brazilian and Argentine competition by the middle of the decade (when the MERCOSUR is to be fully integrated), are very dim.

CONCLUSION: MORE EFFICIENCY IS INEVITABLE

The structural reforms taking place in Latin America follow the principles of "lean production." By liberalizing trade and deregulating, governments are promoting the competition that will force more efficiency in the private sector. By getting out of the production process through privatization and deregulation, governments themselves are also becoming more efficient.

Policy reversals can never be discarded, particularly in Latin America. Some delays and failures in implementation are possible. But they will be more difficult as subregional trade blocks solidify. And as the move toward market liberalization continues, the local auto industry will have to move toward more efficient ways of operating. The local vehicle manufacturers, including the assemblers in the Artdean Pact, must become lean producers, that is, be capable of producing more vehides, more efficiently, with better quality, using fewer resources and lower costs. Inefficient companies cannot survive the high competitive pressures of free markets. By contrast, highly efficient companies can be big winners in protected markets. So, even in the remote probability that the moves toward fleer markets stops short in the next few years, companies would still benefit by becoming more efficient. This is a painful but necessary process in an increasingly competitive world economy.

* Enrique P. Sanchez is Director of Business Economics and Industry Analysis, General Motors Corp., Detroit, MI. The views expressed here are the sole responsibility of the author and do not necessarily represent the views of General Motors Corp.

The large Latin American countries are quickly moving away from import substitution and state-controlled development toward free market concepts. The successful recipe includes price stabilization, privatization, domestic deregulation and trade liberalization. Each country is at a different stage in this process, and some are more successful than others. These drastic structural reforms will bring stronger competition into these traditionally protected markets. They will also force the local auto industry into making the same type of adjustments the North American and European producers are still making today, after three decades of Japanese competition.

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Author:Sanchez, Enrique P.
Publication:Business Economics
Date:Apr 1, 1992
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