Brazil long has been an enigma and never more so than in 2013 as the country struggles with internal and external forces that continue to play havoc with South America’s largest auto industry.

Once a darling among the world’s four strongest emerging markets, coined the BRICs, that include China, Russia and India, Brazil’s coming of age has lost some of its promise as upstart automotive regions in Southeast Asia, South Africa and the Middle East vie to take its place.

Yet true to its history of rise, fall and rise again, Brazil, the world’s fourth-largest auto market, has no intention of fading away, despite a stagnant economy that grew just 0.9% in 2012 and which remains unaffected by government stimulus measures this year. That includes the postponement of the onerous IPI tax increase on vehicles through December, which is estimated to cost the country BR2.2 billion ($1.09 billion) in lost revenue.

Brazil’s overvalued currency, the real, along with high interest rates and slowly easing inflation – down to 5.86% in September from 6.70% in July, according to the Brazilian Institute of Geography and Statistics – also are stalling consumer demand for new cars.

Meanwhile, the industry continues to see profitability slide as new government rules on output and sales drive up competition. The result is smaller margins for suppliers and automakers as costs climb and vehicle prices remain flat.

Regardless of the potholes, WardsAuto/AutomotiveCompass is forecasting record light-vehicle production this year of 3,475,000 units, beating the market’s previous best of 3,411,258 in 2010 and up 8.8% on 2012’s 3,193,712. Output in 2014 should remain strong at 3,754,448 builds, which bodes well for Brazil’s economic future.

Among analysts who study the market, there is agreement Brazil’s vehicle sales and production will continue to grow for the foreseeable future. The country’s auto industry trade group Anfavea in September predicted 2013 output of 3.79 million cars, trucks and buses, up 11.9% from year-ago, crediting a surge in exports and a drop in imports. The group previously forecast a 4.5% rise.

Through October, total vehicle sales were running just 0.6% behind like-2012’s pace, totaling 3,110485 units. Light-vehicle deliveries, which accounted for 2,951,825 of the total, were off a slightly higher 1.4%.

Among the big-volume LV players, Volkswagen (down 13.1%) and Fiat (off 7.9%) suffered the steepest declines through the first 10 months of 2013. General Motors (up 1.8%) and Ford (up 3.1%) managed to remain ahead of year-ago, while the biggest gainers included Hyundai (121.7%), Toyota (65.7%) and German luxury brands Audi (42.2%), BMW (48.6%) and Mercedes (13.3%).

A recent study of the industry’s profitability by strategy consultancy Roland Berger shows despite the gains on 2012 the current economic scenario in Brazil indicates a more conservative outlook for 2013 and 2014, particularly for the parts-making sector, which is forecast to see extremely thin margins of 1%-2% for 2013 due to slow overall industry growth.

Brazil is entering “a period of uncertainty we haven’t seen in six or seven years,” Fiat-Chrysler CEO Sergio Marchionne says, citing the upcoming election as one wild-card factor that is making the market “a little nervous.

“We do not expect the market to deteriorate…but we also don’t think 2014 will be phenomenally higher than 2013.”

Rising Production Costs, Lower Growth Rates

Brazil is not alone in its economic struggles. An International Monetary Fund forecast released Oct. 9 reveals that although emerging markets reduced their primary budget deficits from 4.2% to 1.2% of gross domestic product between 2009 and 2011, lower-than-expected global growth rates in 2011 and 2012 impacted demand for their imports.

Most strikingly, according to a recent report by The Economist, rising production costs in Brazil and China have lowered competitiveness and growth rates in recent years, noting since 2011 their economies have become increasingly reliant on deficit spending for stability.

“Including quasi-fiscal measures, such as local-government financing and off-budget funds, deficits in 2013 surged to 3% of GDP in Brazil and as high as 10% in China,” the report says.

Observers say Brazil’s stagnant economy and inflationary pressure are beginning to cloud President Dilma Rousseff’s 2014 re-election prospects despite her administration’s aggressive efforts to boost the country’s auto industry, one of the main drivers of the economy.

Last year, the government raised the tax on foreign-made cars by 30 percentage points, requiring manufacturers to produce at least some light vehicles locally to avoid the higher tariff. But that action has backfired, according to the Roland Berger report, which says the new rules requiring increased domestic content have created greater demand by local automakers upon suppliers that are not up to the challenge.

“A lot of factories are old and inefficient, without any automation,” says Stephan Keese, a partner in the firm and head of automotive and industrial goods research in South America.

“We expect a new wave of restructuring in the industry,” he tells The Wall Street Journal. “This is (the parts makers’) chance to get through this and return to profitability, but unfortunately we are seeing few players with plans under way to do that.”

Keese says parts suppliers, both foreign subsidiaries and domestic companies, saw their combined investment drop from about BR4.18 billion ($1.90 billion) in 2012 to an estimated BR3.17 billion ($1.44 billion) this year and predicts it will slip to BR3.04 billion ($1.38 billion) in 2014.

It’s difficult to invest when profits are so low. But there are other factors at work, the Roland Berger study points out. These include aggressive new industry players, consumers’ rising expectations and costly legislative changes.

As well, labor costs in Brazil are notoriously high, especially considering the low level of automation, while materials costs for both raw materials and from Tier 2s are significantly higher than global counterparts, the report says.

Currency-exchange rates are an additional burden, as are high logistics costs due to the predominance of road transportation. As a consequence, Roland Berger expects suppliers’ profitability to decline up to 6% through 2014, “despite internal efficiency gains.”

Automakers Remain Bullish

None of this is stopping automakers from increasing their investment in Brazil. GM, for example, opened a new BR356 million ($175 million) engine facility in Joinville do Sul, Santa Catarina, this year to make 1.0L and 1.4L engines, as well as aluminum heads, that will be shipped to its plants in Gravatai, Rio Grand do Sul and in Rosaria, Argentina.

Fiat, reacting to what it sees as a rising middle class, will launch a new 200,000-unit capacity plant in the state of Pernambuco next year that will focus on production of higher-end cars.

“I’m not as negative as some people are on the mid- to long-term performance of Brazil,” Marchionne says. “We’ll live through periods of volatility…but fundamentally the underlying economics are in good shape.”

German importer BMW is building an assembly plant in the state of Santa Catarina as well. Output will begin in 2014 with a 30,000-unit annual capacity for its 3-Series sedan, 1-Series hatchback and X1 CUV. Daimler announced plans in September to construct a factory to produce Mercedes compact cars.

Ford is expanding its lineup in Brazil and transforming legacy products with revamped versions. The new models are performing well, Chief Financial Officer Bob Shanks says, listing the new Ranger pickup, Fiesta small car and EcoSport compact CUV among keys to the automaker’s higher volumes and increased share to 9.5%.

Revenue, operating margin and profit all were up through the first nine months. Nevertheless, Ford CEO Alan Mulally cites expectations for below-trend growth in Brazil in his forward-looking outlook.

Ford, GM, Fiat and Volkswagen are feeling particular pressure. The four have dominated the Brazilian market for decades with a combined 70%-plus share, but now are being crowded by rivals that include Hyundai, Honda and Nissan, as well as a growing number of Chinese and Indian car companies.

“(Brazil) is a place where the Asians, particularly Toyota, always looked at it and said, ‘We don’t understand it. We can’t play there,’” says Xavier Mosquet, global leader-automotive at Boston Consulting Group.

“But for those who are there, who understand the market and have enough market share – the Fiats, the GMs, the Fords – it’s sustainable. If I were a new player, I might say, ‘Let’s wait and go somewhere else, such as Russia, instead.’”

Arguably, the fact the country’s GDP now tops $10,000 per capita is not lost on the newcomers. Indeed, Anfavea expects vehicle sales to surge 68% from 3.4 million units in 2011 to 5.7 million by 2016. And despite its conservative short-term forecast, Roland Berger predicts Brazil soon could overtake Japan to become the world’s third-largest car market after China and the U.S.

Those who understand the market know the auto industry’s journey in Brazil never has been about rolling downhill, but rather riding out the peaks and valleys.

“Brazil has been, I think, 30 years of that story,” Mosquet says. “Again and again. It’s going to continue. But it is still a big market. It is still attractive. It will continue to grow, but we have to realize there will be hiccups along the way.”

– with James M. Amend and David E. Zoia