Carmakers succeed in localizing foreign models

By Lee Hang-koo

Director of Korea Institute for Industrial Economics & Trade

Korea is the world's fifth largest car manufacturing country, and the industry serves as a core engine for economic growth. The industry has also been emerging as a leader of green growth businesses in the 21st century.

In the whirlwinds of rapid change in the global auto market, Korea's vehicle exports in 2009 fell by 19.9 percent to 2.15 million. Domestic vehicle sales increased by 20.7 percent compared with the previous year to 1.39 million.

Korean automobile manufacturers are not only restructuring, but also increasing investment in R&D to develop advanced technologies and improve their models. They are aiming at sustainable growth with green cars in the future. Securing high technology for eco-friendly cars such as hybrid and electric cars is a must to survive the ever-fierce auto market competition.

Korean auto-parts suppliers are also moving to improve their competitiveness in cooperation with the government. While their revenues have been increasing, their engineering capabilities need to be enhanced further.

Local automobile companies have changed their growth strategy from quantity to quality growth. To achieve this, they are emphasizing value propositions to consumers.

The government was crucial in laying the groundwork for the industry. It set up the specifications of individual models, came out with development plans and encouraged automobile companies to put them into practice.

In addition, it led technological development in the early stages of development.

Korea introduced modern car production methods in 1962, with the government setting out policies and enacting relevant laws.Its industrial policy of the 1960s was of great help for car makers.

Domestic demand was so small that the government had to concentrate production with one company ― by the model ― while restricting imports. However, the negative effects of these monopolies became apparent after integration. Local auto companies neglected localization. So the government allowed other companies to enter the auto business.

Export of home-grown models

In the 1970's, automobiles became one of the nation's strategic industries and supported the heavy and chemical industry. The government restricted small assemblers from manufacturing vehicles and shut down some factories. In 1974, the government announced the Long-term Automobile Industry Promotion Plan with the aim of promoting horizontal integration between parts and assembly industries.

Hyundai Motors introduced its first domestic model after eight years of operation and built its general automobile plant with annual production of 50,000 vehicles. The industry had its first independent and integrated production plant. Korean automobile companies were aggressive in improving on this original model.

The government changed the scope of its business so that the frame, engine, transmission, and accelerator were produced in the general automobile plant while affiliates could manufacture drive chains, brakes, and steering assemblies.

It soon realized the limits to the horizontal relationship between the assembly and auto-parts businesses, and so sought another relationship between the two. Horizontal systematization took advantage of economies of scale. A single auto-parts company would supply goods to all the assembly companies.

Vertical systematization, however, lies in the individual setup of auto-parts companies in each OEM so that the assembly companies can support them. Assembly companies provided capital, facilities, technologies and management expertise to auto-part firms.

The systematization policy discouraged parent companies from producing parts. These policies in the mid-1970s laid the groundwork for future industrial development. The development of small cars was emphasized after the first oil shock of the 1970s - production of medium and larger cars was discouraged as they were not competitive globally.

The automobile industry quickly built on the success of its original models but was hit hard by the global oil shock and political chaos at the end of 1970s. The government worked to overcome these problems through its rationalization policies starting 1981.

New policies were introduced to prevent the bankruptcy of OEMs and auto-parts companies. That policy stemmed from the flood of assembly companies that entered the market despite its size. The rate of operation was relatively low, and they were not especially competitive due to the lack of economies of scale. An integrated production system was needed.

Automobile companies established a foundation for exports and Hyundai entered the American market in 1986.

The government reversed policies which previously protected automobile industry from late 1980's to early 1990's. Automobile imports were liberalized in 1988, but with high tariffs ― until 1990, when overall domestic production reached 1 million, tariffs of over 20 percent were imposed.

In 1990, GATT recommended that Korea move toward improving its multilateral trading system. The government constantly lowered its import tariff from 17 percent in 1991 to 8 percent in 1995. The gradual reduction of tariffs helped local makers to cope with imports.

In 1992, a private committee dedicated to developing the automobile industry was established, opening a new era of private-initiated growth.

In the 1990's, when the Korean auto industry started to develop its competitive advantage on the global market, import liberalization was then possible.

Likewise, the industry benefitted from the expansion of overseas production and marked increases in quality. The government's stated objective was to induce localization and develop the auto-parts industries via small and medium-sized businesses.

It would have been difficult for the Korean automobile industry to develop if the market had been left open in its early stages and the entry of foreign OEMs allowed.

Local car makers could increase exports by offering prices lower overseas than at home. This entailed sacrifices by local consumers. Protection of the domestic market was effective in helping local makers sharpen their competitiveness.

Self-driven growth model

The Korean automobile industry could have grown on the back of the self-driven growth model. Although assembled cars were partially imported at the early stage of knockdown assembly, they were restricted to those prepared for domestic production.

In using knockdown assembly, bringing in foreign models could leave the problem of auto-part localization. Importing was more advantageous both in terms of price and quality over domestically assembled units.

In general, competitiveness of assemblers is closely related with that of suppliers. The Korean auto parts industry has been developed through a self-reliance growth model. Korean suppliers have contributed to the growth of Korean OEMs. But the parts industry has revealed weakness in engineering technology and responsiveness to exchange rate fluctuations.

There are some key factors which influenced the performance of Korean automakers. The industry has grown quickly since the mid-1980's, mostly through exports. But the industry in Korea was dealt a harsh blow in 1998 as a result of the foreign exchange crisis. The rapid increase in production capacity in the 1990s created structural problems for Korean assemblers. Debt levels escalated rapidly in the 1990s through easy access to loans. After all, the auto industry paid the price.

To overcome the currency crisis, Korean automakers restructured themselves and sped up their globalization, emphasizing quality management and employee training. R&D investment was also increased, and efforts were made to reinforce brand recognition. In addition, these companies have strengthened their marketing efforts, creating synergy effects, increasing vehicle sales overseas.

Korean auto parts companies could have increased their revenue along with assemblers, but the operational profit ratio gap between suppliers and global players has narrowed continuously. However, that trend reversed itself in 2008 and continued in 2009.

Suppliers began developing modular production systems from the beginning of 21st century, which reduced total supply chain costs and increased profits for local car makers.

Korean auto parts suppliers are solving the long-time problem of size, specialization and internationalization with the help of auto manufacturers and technical assistance center established by the government.

Innovative capability

Despite the global downturn, the local auto industry has thrived in no small part because of coordination between government policy and corporate growth strategies.

Recently, this policy is focused on a system of innovation, building up the basic capabilities including cost reductions, quality improvements and reduced delivery time. The government also promotes the development of the production structure and facilitates aimed at domestic demand.

Korean auto companies, universities and research institutes are working together to develop a technology infrastructure for green vehicles. It's difficult to predict which technology will be the de facto standard for environmentally-friendly vehicles, so automobile companies must invest in every possible green technology. That increases R&D costs for automobile companies, some of which has been provided by the government to support the parts industry.

The commercialization of green vehicle can be realized earlier than expected if auto companies expand strategic partnerships with their competitors. The government is developing R&D projects with technical assistance for leading car companies. Developing human resources is a crucial factor to green vehicle development. In this regard, technology assistance centers play a key role in training workers and certifying new technologies. For Korean automakers to leap forward in the global market there is an urgent need to produce fine quality products at competitive prices.

Positive Effect of FTA policy on Automobile Industry

FTAs have mushroomed as they have proven the best way to liberalize trade. They will change the industrial environment as the government proceeds with its free trade policies with a gradual opening of markets.

The government can facilitate cooperation among automobile companies and support the auto industry through various measures. In order to maximize the positive effects of a FTA, active participation by the government, private sector and consumers will be required.

Governments of member countries should create an open innovation system to encourage cooperative R&D projects, pursue standardization of developed technologies and support strategic alliances. Such cooperation can help resolve issues and identify challenges in the industry.

Institutional cooperation between countries can increase consumption and thus increase domestic demand. This, in turn, will strengthen the growth potential of the member countries' auto industries.

Strategic partnerships between auto companies can lead to increased competitiveness. Government-led R&D projects should be established with technical assistance from leading car companies. Member countries should gather their competencies and share resources effectively.

After all, the auto industry will respond to globalization through FTAs. The elimination of tariffs and non-tariff barriers will expand export markets and direct investment opportunities. Strategic alliances among firms in member countries can provide value-added auto products and services. Establishment of an efficient regional supply chain also can promote specialization, globalization and growth of auto parts suppliers.

If FTAs do come into effect, auto companies can alleviate yearly tariff burdens on autos and auto parts. They can then use those savings to develop new models, improve production processes and promote sales, all leading to a stronger market position.

Five factors to overcome recession

What are the factors that have had a positive effect on the Korean auto industry's recent performance.

First,

Korea has a small- and medium-sized car production structure and that led to an increase in passenger car sales in developing countries. The share of production by small cars (engine size smaller than 1,600cc) was 58.8 percent and large car (engine size bigger than 2,400cc) production share accounted for 20.1 percent in 2009.

So, the import penetration ratio is higher in the large car segment than that of small cars.

Second,

efforts to strengthen basic capabilities have had an effect on creating more value for customers. U.S. Consumer Reports evaluated Hyundai's reliability next to Lexus in 2009. That means Korean parts industry's quality competitiveness has reached the world's top level.

Third,

Korean automobile companies have increased R&D investment significantly since 2004. Hyundai's average growth of R&D recorded 64 percent annually from 2004 to 2007. With that investment, Hyundai and Kia have developed new technologies and introduced new models. The R&D intensity ratio of Korean auto parts companies also rose to 3.4 percent in 2007, but lower than that of global players.

Fourthly,

the government's timely tax incentives contributed to boosting domestic sales. Until 2008, polarization and high-oil prices deflated vehicle sales in Korea. The Korean government lowered the special consumption tax rate by half when the financial crisis broke out and expanded tax incentives for vehicle purchase. Such a quick policy response restored vehicle sales in the second half of 2009.

Lastly,

financial support by the government and assemblers for the auto parts industry prevented the bankruptcy of small- and medium-sized parts companies. Improved government systems monitoring supplier cash flow and increased regional cooperative funds with OEMs, local governments and financial institutes created a smooth supply of parts and components to assemblers.

The writer is a director of Korea Institute for Industrial Economics & Trade. He received his MBA from the University of Washington and a Ph.D. from Kookmin University. Lee has focused his research on international business strategy, and the auto and design industries. Currently Lee is an advisor for the Green Car Forum of the Ministry of Knowledge Economy; chairman of the Collaboration Study of Small and Medium Business Administration; vice chairman of the Korean Academy of Motor Industry; an auditor for the Korean Design Management Association; and an executive director of the Korea Academy of strong Medium Enterprises.