Problems of Iran’s car exporters: political expediency or economic success?

By Mehrdad Emadi

Publication of the most recent data on the export performance of Iranian automotive industry has invoked new interest and concerns about what appears to be an underlying trend in the declining competitiveness of the country’s auto manufacturers especially for the leading two firms, namely Iran Khodro (IKCO) and Saipa whose market share exceeds 91% of sales of passenger cars in the country.

Announcement of a 26% fall in the value of exports caused by a fall in the volume of 25% in the first five month of the current fiscal year depicts a worrying picture of the health of the industry. Given the prominent role of the industry as both a key employer and its potential as the main non-energy earner of foreign currency, makes the export figure of 10,000 units in the last fiscal year (march 2016 to march 2017) registers a 59% fall in exports from 24,500 units for an industry that produced more than one million cars (1.16 passenger cars and other vehicles) in the fiscal year 2016.

Given the stated goal of reaching a production level of 3 million cars with a million exported by 2025, the fall in export figures suggests serious underlying issues in the industry that almost certainly will fall substantially short of its export targets and the quality upgrading that is needed to achieve export expansion in the next eight years.

This note provides a brief background to the automotive industry’s developments in Iran, its historical performance since its inception in 1962 and the extent to which political considerations have besieged the industry and have prevented it from reaching its true potential.

By comparing the performance of the Korean (ROK) and Turkish car manufacturers with their Iranian counter parts, it is suggested that the root-cause of the under performance in the Iranian automotive industry might have been continuous political interventions and lobbying at the cost of good economic governance.

We categorize factors governing the growth and development of the automotive industry into factors internal to the national characteristics of the country (natural resources, geographical location, human capital, trade and industrial policy, and quality of management) and those factors which are external though not independent of the first group.

Although issues such as access to the international capital markets, leading foreign technology, licensing requirements and proximity of foreign competitors to domestic producers and the extent to which external pressure impacts on the operating margin of firms in the Iranian automotive industry have all played a role, I suggest that the most fundamental obstacle is the way in which economic decisions have been made based on political lineages and group affiliation instead of considerations based on how to enhance the competitiveness and solvency of the industry and the economy at large. Below I touch upon some aspects of this problem.

Choice of foreign partners

Iran’s first car manufacturer IKCO was founded in 1962 with its first car, a medium size car named Peykan (based on an already semi-obsolete British sourced Hillman Hunter engine and platform. The name itself was a translation of Arrow used by Hillman) that left the factory gates in South West Tehran in 1967. The car continued being produced till 2005 well after the British firm had seized to exist.

Iran’s choice of foreign partner for its automotive industry was the most inauspicious beginning. Iran’s automotive industry had chosen the worst possible partner in Europe that was perceived to head toward bankruptcy notorious for the poor quality of its cars (at the time the partnership was seen as a preference of the late Shah of Iran to sweeten the cooled off relationship with London). Based on this choice of foreign partner alone, it would be safe to say that Iran did not see its automotive industry as a source of export earnings and innovation in design and engineering. With substantial tariffs created to protect the infant industry (Korea and Turkey also adopted similar policies), the focus seemed to be on import-substitution rather than export-expansion.

In this aspect Korea took a separate path very early from Iran (and Turkey). First the choice of foreign partners approved by the government in Seoul showed that the value of partners from a single country with its firms making strides in expanding their markets abroad reflected the desire to follow suit and create a lean and competitive manufacturing structure that within couple of decades became a key competitor of its Japanese partners and by 2005 overtook their sales in some of the key export markets.

The focus in Iran stayed on supplying the domestic market with some symbolic foreign sales in the neighbouring countries where through massive price discounts Iran managed to showcase its National car. However, the desire to become a competitive exporter in the sector never took root amongst the policy makers in Tehran. When the time arrived to replace the British firm, instead of seeking a market leader in terms of technology and market penetration know-how, Iran chose Peugeot of France, another heavily indebted car manufacturer whose survival had been made possible through different aid and protective measures provide by the French government (Honda and Mazda both had expressed interest in becoming the new partners in the deal).

And once again similar to the British partner, what the French partner offered the Iranian side was the technology and platform of the older generation of its models often phased out because of their technical and design flaws. By 2002, Korea had become a creator in its design and engineering of new platforms and even Turkey had made strides in creating indigenous technology and improves productivity comparable to those amongst the second tier Western manufacturers (Renault, Fiat, Chrysler and others).

Domestic political change and uncertainty meant that by the late 1970s Iran was showing signs of change in its social and political landscape. The 1979 Revolution created massive changes in the economy of Iran. Most notable amongst those was the mass Nationalisation and/or confiscation of the assets of those who were seen as pillars of the old Regime. By the time of the Revolution, Iran had managed to develop three assembly lines in passenger cars and two in light truck and vans. Foreign partners in addition to the British firm used by Iran Khodro (then Iran National) were GM of the America and Renault of France. Mazda also had foothold in the commercial production in the country. Confiscation of assets and the eventual Nationalisation of some key parts of the industry, regrettably for the future of car manufacturing in Iran resulted in a number of changes some of which, in my view became the root cause of the chronic underperformance.

Changes in the ownership of the firms have had significant consequences in the management of the industry. Most notable amongst them was the move from a hard-budget constraint under which the company had to meet its financial obligations in order to continue its activities to soft-budget constraints under which payments to suppliers and even workers could be delayed or adjusted to cover the gap between income and expenditure.
The newly appointed managers who were often promoted because of their political loyalty were often unsuitable for the task and many inferior choices were made during the transition period. Furthermore, government saw the production facilities as part of its domain and would signal its desire to the new appointees to recruit new workers as part of job-creation and the expansion its base in the labour market without considering the fallout from such practices for the future competitiveness of the manufacturers.
The 1980-1988 war following the surprise Iraqi attack on the Southern and Western provinces of Iran further exacerbated the auto industry’s financial well being by reducing new investment in plants, shortage of parts and components in the assembly line where GM was the foreign partner who left Iran shortly after 1979 and the inflationary pressure that accompanies all military operations. During this period, the automotive sector in Iran became over staffed and under-invested in its production lines and was encouraged to meet quantity targets (instead of quality upgrading occurring elsewhere) which were the quanta used by the government to allocate funds and foreign exchange. Below a cursory comparison of the employment and output of the automotive industries for a small selection of countries show the extent of low productivity in the Iranian automotive sector.

The figures below are for the fiscal year 2015-2016. Total output is the aggregation of passenger car production and commercial vehicles.

Country

Total Output

Workforce

Vehicle per worker

Iran

1.16mil

0.719mil

1.6

Turkey

1.48

0.230

6.4

Korea

4.22

0.246

17.1

China

28.11

1.6

17.5

Russia

1.30

0.755

1.7

Egypt

0.036

0.073

0.5

The stark contrast between labour productivity in Iran with those in Turkey, Korea and China is most likely caused by labour hording that is symptomatic of state-owned enterprises and chronic under-investment.

My own experience during the period 1990-2004 in the CEEC after the privatisation started in these countries in Europe uncovered similar problems most notable amongst which was the endemic labour hording by firms whose managers saw the staffing numbers as an effective means to ask for more resources. The similarity between the labour productivity in Iran and Russia may be seen as another example of when firms operate under soft budget constraints and are not forced to honour their debts to their suppliers.

On the other hand, the financial discipline imposed by competitive markets forces firms to enhance labour productivity through the selection of most appropriate technology and capital equipment to ensure profitability and financial growth. It is noticeable that China shows the same productivity gains as Korea when market rule, hard budget constraints and export-orientation form the underlying metrics guiding the management.

Egypt is the other extreme when a totally protected market with no outside competition and strict intervention of the State hampers productivity gains and good performance. There is nothing intrinsic about the poor labour performance in Iran (or Russia for that matter). It is the combination of good apolitical corporate governance, incentive compatibility between market demand and policy and investment allowances that has turned the automotive industry in Korea, China and to a lesser degree Turkey into lean and competitive producers and the absent of such a packages in Iran (and Russia) that has resulted in an indebted, underperforming and uncompetitive industry.

The imposition of sanctions specially the latest sanctions proposed by the U.S. in 2009 and adopted by the EU later where the automotive industry was directly and indirectly, affected Iran’s automotive industry most severely. The hurried exit of the French partner from the country left Iran’s automakers in a lurch. Iranian authorities encouraged the automakers to increase component production by their domestic firms but the management of the assembly line sought relief by turning to Chinese component makers.
The replacement of European parts by Chinese substitute resulted in a significant fall in the quality of domestically manufactured cars. This is captured in both the reported failures during the period of Warranty Cover as well as by complaints registered in the export markets of the neighbouring countries where the cars were offered for sale.
The Italian Trade Agency reports in a recent study of the Iranian automotive industry that, “Prior to the tightening of the sanctions, Iran produced high quality auto spare parts conforming to international standards. The sanctions, however, slowed the industry's development and left auto manufacturers with no choice but to purchase low quality Chinese products, which considerably impaired the quality of Iranian cars.

The same study reports that, “As the sanctions imposed forced the Western companies to withdraw from the Iranian market, the domestic players tried to cover the demand-supply gap of auto parts through localization and import of Chinese spare parts. The plan flopped as the both the local and Chinese products could not compete with the Western quality standards. The sector showed a sharp decline of 30% between 2011 and 2013 as the companies faced reduced sales and high receivables. The auto part manufacturing sector has been the one registering the largest number of bankruptcies in Iran. Nearly 50% of all firms filing bankruptcy are auto part manufacturing companies.” (Market Overview of Automotive Sector in Iran, Italian Trade Agency).

By 2014 nearly half of the components imported by car manufacturers were Chinese made.

The net outcome of this resourcing has been a measurable fall in the quality-adjusted price and the reputation of cars manufactured in Iran. Using unit value of vehicles adjusted for quality, the figures below show the gap in the value of cars produced per worker annually and the subsequent estimated profit per unit for each country. All the monetary values are in the U.S. dollars for 2015-2016.

Value per worker as a measure of quality-adjusted output

Country

Vehicle per worker

Ave value

Per vehicle US$

value of output

Per worker US$

Iran

1.6

4,500 (-6%)

7,200

Turkey

6.4

5,900 (+2%)

37,760

Korea

17.1

17.200 (+5.2)

294,120

China

17.5

6,200 (+1.2)

108,500

Russia

1.7

------

--------

Egypt

0.5

2,650 ---

1,320

Because of overstaffing (labour hording), older technology and production methods and inferior product quality, revenue per worker in Iran is less than one-fifth of that of Turkey. Comparisons with the similar figures for Korea and China reveal the depth of productivity crisis in the automotive industry in Iran.
The higher quality of the finished vehicle when reflected in their higher market price multiplies the gap in the output per worker between Iran, Turkey, Korea and China. A big part of the price difference is the perceived quality that includes after-sale services and support. The figures in the parenthesis are estimates in the Hedonic Quality Index used to measure changes in the quality relative to the average for the vehicle. Iran’s negative figure is mostly caused by the introduction of Chinese parts in the production line.

In spite of the disconcerting picture depicted by these figures the attainment of a lean, financially solvent and competitive auto industry is still possible. It is my considered assessment that the existing problems may be resolved and the auto industry can follow the success story of other economies should the macroeconomic environment adopt a pro-competitive stance where the wall of protection through import duties is set to end in the near future and if the government introduces hard-budget measures to force the chronically poor managed firms out of the industry.

The example of the Republic of Korea suggests such bankruptcies need not be terminal and better managed firms could absorb the weaker firm and force them to lean out and adjust to competitive forces. Iran’s educated young people, the quality of the engineering and technical programmes at universities and the location of the country with easy access to a consumer market of 400 million provide strong cases for investing in the industry.

The low level of car ownership of 80-100 per 1000, compared with the average of 600 per 1000 in Europe and the age distribution of the nation there exists the promise of a growing market with inexpensive labour force. It is also true and historically supported that the automotives is the most effective means to technically educated and acquire the knowledge base needed to compete successfully in the global economy.

World Bank as well as Italian Trade Agency report a GDP contribution of Iran 10% made by the auto industry and an employment of more than 4% of the labour force. Albeit some of it is hording, still the prospects for employment and income growth are too promising to ignore the problems of the industry. In its present conditions, far from ideal, the sector is estimated to have made a contribution of more than $9.2 billion to the economy. For each one person directly employed, the industry creates five extra jobs. The early arguments for creating a robust national automotive industry because of the size and the terrain of the country and its neighbouring economies still hold true.

Even during the harshest period of sanctions, its market was significant. In 2014, according to OICA data, total market sales - including commercial vehicles - placed the country as the thirteenth largest auto market. At its peak, in 2011, with nearly 1.7 million sales recorded the country ranked as the 11th biggest market in the world. Its size makes it the largest automotive industry in the Middle East and the lifting of sanctions could make it an attractive regional hub.

With increasing financial discipline, an export-oriented production plan awarding exports through tax exemption and financial partnership, a widespread privatization programme and a return to sound economic management of the industry based on financial metrics, the achievement of China in this sector is within our reach. Thirty one years of studying, researching and advising in this industry lend me a little credit in stating that we can achieve success for Iran in this sector.

Mehrdad Emadi is an economic expert and consultant at the UK-based Betamatrix International Consultancy.

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