Russia's Automotive Market is Nothing if not a Paradox.

New-car dealerships stand next to dilapidated Soviet-era apartment buildings, while flashy Ferraris and Lamborghinis travel alongside aging Ladas over pothole-ridden streets.

Since the collapse of the Soviet Union in 1991, Russia has returned to the land of “haves” and “have-nots,” with foreign auto makers targeting the former, and domestic makers left to market their antiquated vehicles to the latter.

“The wealth discrepancy is huge; it's almost like two car markets,” says Carol Thomas, an analyst with J.D. Power Automotive Forecasting in Russia.

“You have the big-city car markets that are like Western Europe and the emerging car markets, which are further out (in rural territories).”

Yet, many analysts say Russia is poised to become Europe's largest car market by 2012, with light-vehicle sales of foreign brands, on average, growing at double-digit rates. Through September, foreign auto maker sales climbed 40.0%, compared with year-ago, to 1,611,840, J.D. Power data shows.

Russia's two major cities, Moscow and St. Petersburg, account for most of the demand. Observers argue that for growth to continue, outlying markets must be developed in this massive country encompassing 11 time zones. And Thomas says the market is starting to spread beyond the main urban centers, albeit at a slow pace.

In eastern Russia, nearly all vehicles sold are domestic makes, led by the country's top auto maker, OAO AvtoVAZ. Since partnering with the Renault SA-Nissan Motor Co. Ltd. alliance earlier this year, AvtoVAZ has undergone somewhat of a renaissance, says Ivan Bonchev, senior manager and automotive leader-Commonwealth of Independent States for consultancy firm Ernst & Young.

“(AvtoVAZ) has been working on coming up with a completely new model range for (the last) two years,” Bonchev says. “To what extent they're successful, it's too early to say.”

Until new product arrives, AvtoVAZ remains dependent on its aging Lada cars, which sell upwards of 700,000 units annually. But as consumers become more techno savvy, Lada's grip on the market appears to be weakening. Sales fell 9% in September, J.D. Power says.

Although local brands still account for 60% of Russia's domestic sales, foreign makes rapidly are catching up. General Motors Corp.'s Chevrolet brand is the top-seller, followed by Hyundai and Ford. In terms of overall sales, GM ranks No.1, followed by Ford Motor Co., Hyundai Motor Co. Ltd. (including Kia Motors Corp.), Toyota Motor Corp. and Renault-Nissan.

GM has said it expects Russia to become its largest car market in Europe by 2010. The auto maker at one time had two assembly plants, the first a joint venture operation with AvtoVAZ, which since has been dissolved.

The most recent is wholly owned, located in Russia and planning to begin building the Chevrolet Captiva and Opel Antara cross/utility vehicles later this year. In 2009, production will begin for the all-new Chevrolet Cruze compact sedan unveiled in Paris in September.

Ford, which launched operations in St. Petersburg in July 2002, lays claim to being the first foreign auto maker to open a wholly owned assembly plant in Russia. The St. Petersburg facility builds the Ford Focus C-car in four body styles: 3-, 4- and 5-door models, plus a wagon, and is ramping up to add the larger Mondeo.

Nigel Brackenbury, president-Ford Motor Co. ZAO, says despite the market's recent downturn, primarily due to deteriorating global economic conditions, the auto maker remains bullish on the country's growth potential.

“New-vehicle ownership in Russia is still very low, compared to Western Europe or even Eastern Europe,” which presents considerable market potential, Brackenbury tells Ward's during a recent interview in Moscow.

“Vehicle ownership is around 200 units per 1,000 (people),” he says. “In Western Europe, depending on the market, it's 400 to 500. The country has strong economic growth. Manufacturing is developing here, and the outlook remains relatively buoyant for good gross-domestic-product growth.”

Brackenbury insists that in order for a foreign auto maker to succeed in Russia, it must produce vehicles locally. “Russia is a long way from most places. To bring volume in and get it close to the market, you want to be building close to where you sell. Our logistic times from our European plants are relatively high.”

Import tariffs of 15%-25% also bolster the business case for manufacturing within the country.

Ford in September had a waiting list for its locally built Focus, with demand outstripping capacity. That's a good problem to have, Brackenbury says, adding the auto maker has been careful not to saturate the market, enabling it to sell vehicles at a premium.

There are challenges for foreign car makers in Russia, compared with the more-developed industries of Brazil, India and China. Among them is a lack of suppliers, although the situation is improving.

“We've had to work very hard on developing a local supply base,” Brackenbury says, noting the government requires foreign makers to source 30% of their parts from domestic companies.

Government creates more red tape by making the export of vehicles from Russia an expensive proposition.

“There are high duties on vehicles manufactured in Russia and sold in Western Europe, and there are high logistic costs,” says Brackenbury. “I think some manufacturers have low-volume exports from Russia, but they're mostly to former Soviet republics.”

There also are uncertainties that separate the Russian market from its fellow emerging markets.

“The population is declining,” Thomas says. It presently stands at about 141 million and is forecast to decline 6% by 2020, due to the low birth rate and average life expectancy — just 60 years for males. “The crucial thing is the working-age is declining as well.”

Additionally, environmental issues largely are an afterthought to both government and consumers. The country currently mandates Euro3 emissions standards, with plans to adopt Euro4 guidelines next year, whereas Western Europe is moving into Euro6.

Hybrid-electric and other alternative-fuel vehicles pretty much are non-existent in oil-rich Russia, where the price of gasoline is subsidized, costing consumers about $0.69 per liter.

The lack of a used-car market also is unusual. “Legislation here precludes (its) development,” Brackenbury says. “It's basically a double value-added tax. If a dealer buys a used vehicle as a trade-in and reconditions and sells it as a used vehicle, he pays VAT on the (total) sales price. In most markets, you usually pay tax on the margin, which makes sense.”

Auto makers are lobbying the government to do away with the double VAT, he says. Meanwhile, the majority of used-vehicle transactions are conducted between private parties, rather than trade-ins on new cars.

Buying a vehicle on credit is difficult for Russian consumers, even in the best of times, because the financial infrastructure is not yet in place, although Brackenbury says that is changing. Currently, about 50% of new-vehicle purchases are financed and the rest are cash.

“But as financial institutions continue to develop, it's going to make (credit) more assessable,” he says. Of the 2.4 million vehicles sold in 2007, 1.2 million were bought on credit. Typical loans through September carried an average interest rate of 9%-11% in foreign currency and 11%-13% in Russian rubles.

Most foreign auto makers, including Ford, have yet to set up financing arms due to the complex regulations, but it would be prudent to begin doing so, Ernst & Young's Bonchev advises. “Given the size of the market and the future development, it makes sense to look at the establishment (of a credit institution) when the business case merits.”

Despite the roadblocks, industry observers say Russia's growth has been remarkable as global auto makers scramble to establish production operations and sales distribution networks there.

J.D. Power predicts Russia will hit 4 million light-vehicle sales by 2012, up from an expected 3 million this year. By 2020, the industry could reach 5 million units, Thomas says. “That's where the economic growth curve is (headed).”

Earlier forecasts had pegged the market to climb to 5.2 million units by 2012, but that estimate recently has been revised downward as the global financial crisis spills over into Russia.

The dollar-denominated Russian Trading System since mid-May has lost two-thirds of its value, although ordinary citizens have yet to be affected by the economic onslaught, The Economist reports in October.

“Many have found it harder to borrow money, but state television has tended to play down the crisis,” the news magazine says. “Big job or wage cuts have yet to materialize.”

Thomas says the current turmoil is bound to affect car sales. “What is driving the collapse in stocks, falling oil prices, is much more critical in terms of what it means not only for Russian economic growth but also for confidence,” she says.

“Roughly speaking, a $20-per-barrel drop in the forecast oil price means GDP growth will be lower by as much as 2%.” This means predicted consumer spending growth of 12%-15% just a few months ago now is expected to be less than 10%.

“In the short-term, consumer confidence is likely to be severely shaken by recent events, so that even if credit availability improves going into 2009, we are expecting a much smaller increase in (new-car) sales than we were just a couple of months ago,” Thomas says.

Dealers and suppliers have been hit as well, forcing auto makers to cut production as thousands of workers throughout the country reportedly are being laid off from their jobs. In an attempt to prop up the ruble, the Russian central bank on Oct. 7 sold $4 billion in cash reserves.

Despite the market meltdown, Magna International Inc.'s co-CEO said at an Oct. 6 news conference that he still sees a strong future in Russia.

“We know the Russian market is depressed, as it is worldwide,” Siegfried Wolf is quoted telling reporters. “The automotive market, itself, is under a lot of pressure at the time being. But the future is in this market. We will work and continue with our plans.”

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