Among the U.S. auto industry’s many challenges are the ongoing negotiations between General Motors and the United Automobile Workers union aimed at coming up with a new contract to replace the one that expired on September 15. A major sticking point seems to be GM’s plan to turn over health care expenses to the UAW by way of a trust that would cover GM’s unfunded health care obligations to employees, retirees and their families. Other issues roiling the industry include the recent takeover of Chrysler by private equity firm Cerberus Capital Management, a possible slowdown in consumer spending as a result of fallout from the subprime mortgage crisis, and reported efforts by India’s Tata Motors to take over two of financially plagued Ford Motor’s luxury brands, Jaguar and Land Rover. Wharton management professor John Paul MacDuffie, co-director of the International Motor Vehicle Program, spoke with Knowledge at Wharton about these and other issues.

Knowledge at Wharton:  Regarding the negotiations between G.M. and the UAW over health care benefits and the creation of a trust, how would it work and why would the union agree to this?

MacDuffie: Those are very good questions and there are negotiators laboring away in windowless rooms right now, in the Detroit area, trying to solve them. This is probably the most striking feature of what I think are correctly labeled historic negotiations this year between the UAW and the Big 3. GM was picked as the first target [because it is] probably the healthiest financially at the moment. This is not to say that this makes them all that healthy.

The trust is something that has been done once before on a kind of experimental basis in the auto industry, both at GM and Ford. It puts funds into the trust which can be used for health care liabilities and the trust is then managed by the union. After the GM and Ford experience, this has been used twice with supplier companies. Both Goodyear and then, more recently, Dana negotiated these VEBAs [Volunteer Employees Beneficiary Association Plan].

So, there is beginning to be a little bit of experience with them. But the scale of what would be involved to do this for GM is of such a magnitude that it would be difficult to predict exactly what will happen.

Knowledge at Wharton: Billions, like $50 billion, $55 billion?

MacDuffie: Exactly. One of the big issues is how much money gets put into the fund up front and where does that money come from? The companies would like to put in as little as possible at the beginning and hope that the funds they put in will accrue at a rate that will cover the eventual liabilities. People will be retiring over time — these costs are not incurred all at the beginning. The union would like that amount to be as high as possible.

If we look at the precedent, both the Goodyear and the Dana settlements were funded at about 70% to 71% of the calculated health care liabilities. In the run up to these negotiations, analysts were saying that GM would probably shoot for 50% — wanting to fund at a level of 50%. The UAW would be thinking of something more like 90%. So already that reveals a big gap; those percentages apply to very big numbers.

The next issue is where does the money come from? Is it put in as cash, or is it put in as stock? If a lot of it is based on stock, then the future amount in the fund depends on the future stock performance. So that’s a kind of bet by both sides on exactly what the future performance of the company will be.

Just from some of the press coverage that I’ve seen, I understand that there is talk of some contingencies that would deal with unexpected future events affecting the total amount in the fund. I guess one possibility that this contingency would cover is what if the fund generates huge surpluses? What if the U.S. implements a national health care plan and suddenly a lot of those costs are taken off the back of the fund? So there would be a provision to handle that, probably more importantly for getting the union support and also some provision if the funds run out.

Part of the experience with the small experiments at GM and Ford was that the funds ran out much sooner than expected. So the union has that in their very short-term memory as a risk.

Knowledge at Wharton: There’s a pretty big gap between the 50% figure that GM wants to fund it with and the 90% figure that the union wants GM to fund it with. Where do you think they’ll end up?

MacDuffie: It’s hard to predict because I think it will be combined and interacted with many other features of the deal. But, I think that the union will be aware of the political risks for the union leadership [if they bring] forward a proposal that looks like it’s giving away these hard won health benefits or putting them at risk.

After all, the leadership can only put together a contract — but it has to be voted on by the membership. The health care concessions that the UAW made to both GM and Ford in the last couple of years were approved by a very narrow margin. In fact, at Ford it was narrow enough to make everybody very, very nervous. So if they put together a deal that doesn’t get ratified, then it’s much more politically complicated to put a new package together.

Knowledge at Wharton: What’s your prognosis of how the deal will work out this time overall?

MacDuffie: Well, my sense is that both sides are ready to try to do something very different here. I mean they could end up with something that is more of a continuation of past patterns — but it wouldn’t really deal with this health care problem. My guess is that there’s a lot of energy going into trying to find a creative solution to this. That will probably push up the level higher than GM originally wanted. But it will probably be less than the union wanted because of some of these contingency plans which may reassure some of their concerns.

You know, with the Goodyear and Dana benchmarks of around 70-71%, and given that the automaker workers have thought of themselves as kind of the aristocracy of the blue collar, for them to take a deal that’s not as good as the Goodyear and Dana workers would be tough. So I wouldn’t expect it to be below that level.

Knowledge at Wharton: If we can switch gears and talk about Chrysler for a moment. A few weeks ago there were reports about them hiring away James Press, the head of Toyota’s North American operations. And, of course they have their new CEO, Robert Nardelli. What do you think the outlook is for Chrysler in the coming year?

MacDuffie: Well this is another, in a sense, completely new terrain. There’s never been another automaker owned by a private equity firm and perhaps no private equity firm owning such a large and iconic company. So there are a lot of things to watch. The new owners did state, very clearly, that they intended to invest and rebuild Chrysler. They were not interested in what many often assume is the basic private equity motivation, which is to turn and flip the assets quickly.

It was quite important to get the head of the UAW to say that he would support the deal. And in putting together what some consider a kind of dream team of automotive and executive talent to run Chrysler, it seems to back that up. Now, Nardelli’s reputation from GE, but even more from Home Depot, is certainly as a cost cutter more than anything else. So that perhaps brings some anxieties on what his preferred and natural approach will be.

Many people, and I would agree, have thought that Chrysler’s problems are more on the revenue side than on cost side. They’ve got to get their product mix right and begin to attract consumers on that basis. Jim Press, on the other hand, has an absolutely stellar record of building Toyota sales in North America and is a proven revenue booster. You know, Toyota has had people poached from them during the years that they have been so successful in the U.S. before — but never an executive who was anything like the level of Jim Press.

And of course Jim had recently been appointed as a member of Toyota’s Board of Directors — the first non-Japanese in that position. So if I think of examples where other people have left Toyota with the intention of applying Toyota’s methods in another company, it turns out that there’s an awful lot in the broader organizational culture and organizational systems that make it possible for that person to execute so well. Jim will be stepping away from all of that at Toyota and into a different situation.

On the other hand, sales has always been more customized to the market, and the Toyota sales organization in the U.S. has very successfully, I think, argued with Japan about the best way to sell cars in the U.S. So, these are not really the things that he will bring in terms of insights into selling cars in the U.S…. It’s a question of whether the people and the systems and the culture behind it will work.

My sense is that Jim Press was approaching probably the last few years of his career at Toyota, where they quite strictly do ask people to retire at a certain age. This Chrysler opportunity was a challenge probably greater than any he would have been offered at Toyota.

Knowledge at Wharton: I have a couple of questions about Nardelli. First, I wonder if you have any first impressions of how he is doing. And second, at Home Depot he faced certain interesting challenges in dealing with shareholders which are particularly relevant because Home Depot is a public company. Now, in an environment that is controlled by a private equity entity, I wonder whether you feel his leadership style will be a positive or a negative in this new context.

MacDuffie: Well, he won’t have to deal with shareholders, so that’s the first obvious plus. Although, people talk about this being a kind of redemptive opportunity for him; he might look for opportunities to redeem himself on that front as well. I think running an auto company is a big and complicated job even if you come from within the industry. He obviously comes from outside.

Alan Mulally at Ford has shown quickly that he’s determined to have a clear and simple strategy; to remove various obstacles to that, to stay focused on a few central challenges and then to work closely with the people who really know the business. So, to see Nardelli and the other people at Cerberus putting together a strong team is a good sign. How Nardelli then manages that team, I think is the real key.

It’s certainly true that there were many reassurances at the time that the sale was announced that the cost saving plan, which Dr. Zetsche from Daimler Chrysler had announced, was as far as they were going to go with cost cutting. But I did see recently that Mr. Nardelli said in light of the sub-prime crisis, in light of the credit crunch and in light of the impact on car sales, there might need to be a reexamination of that. So, that seems true to form and would again perhaps stir up some anxieties that he’ll reach for the cost cutting lever first.

Knowledge at Wharton: With all of the fall-out from the sub-prime mortgage crisis and hints of less consumer spending and lower consumer confidence, what’s the outlook for the auto industry?

MacDuffie: Well, it’s sensitive to interest rates and it always has been. Cars have a longer life than they ever have. Often upgrading a vehicle or getting a new vehicle at the end of a lease is more of an option than an absolutely necessary activity. I think it is in that sense an immanently postponable thing for people. And the U.S. has a very thriving used car market which is where people often turn if they are feeling pinched.

The other variable is gas prices and product mix, particularly of the Big 3 automakers. Products that are relatively expensive and not very fuel efficient are going to be even more vulnerable. But anyone who truly needs a car and wants some of the new fuel efficient offerings that are relatively new in the market, probably has to go to the new market, or perhaps to a part of the used car market. I don’t expect a deep, deep drop. But these are conditions that will make it harder for GM, Ford and Chrysler precisely at a time when they could have used a boost.

Knowledge at Wharton: I wonder if we could now turn to some questions about India. Tata Motors, India’s largest car maker, has been in the news for the past few weeks, because of reports that it’s interested in taking over Jaguar and Land Rover, two Marquis brands that the Ford Motor Company has put up for sale. So, let’s start with a couple of key questions there. Does it make economic sense for Tata Motors to take over Jaguar and Land Rover from Ford? And, what would Tata Motors do for these iconic brands that Ford could not do?

MacDuffie: I think that there are probably several interested buyers of Jaguar and Land Rover that may share certain attributes. I think for a company in a developing country that’s looking to put itself on the map in this industry, particularly Tata, which would not be a new entrant, but certainly with passenger cars and certainly in this high end luxury segment, they would be very new. And, as a former British colony there might be a certain sense of pride in acquiring the “Jewel in the Crown” so to speak.

One of the advantages that you might imagine is that India is a low cost manufacturing base. This is not very much a factor here. I suspect that as a condition of the sale that Ford would insist that the buyer not move manufacturing outside of the UK — at least not right away. There are a lot of political sensitivities in the UK about that with respect to the auto industry.

Tata has admirable cost reduction skills as they have shown in the development of the Indica, which is a small car. And there is great excitement and impatient interest in the so called $2,500 or Rs 1-Lakh car which Tata has been promising for some time. People have looked at this closely and think that Tata has a lot of the skills to really do that. So the company that is quite savvy about cost control can probably apply those skills even to a luxury car segment.

Ford has been investing in Jaguar and Land Rover. Land Rover actually sells at a pretty good margin; Jaguar is more financially troubled. Ford is selling not so much because these brands are in the worst trouble that they’ve ever been in, but simply because Ford’s overall crisis and Mulally’s desire for focus is pushing them towards just concentrating on the core business.

So Tata or any new buyer could pick up these firms presumably at a pretty good price and at a point where they are already on the upswing towards being in better shape. And that might make it easier to look triumphantly like you’ve managed them beautifully.

Knowledge at Wharton: News reports suggest that while India’s car market is smaller than China’s, it’s growing at 20% a year, which is faster than the Chinese market. What factors are driving this growth and what are the implications for global auto companies?

MacDuffie: Forsome time the fact that the China market growth rate was so much higher than India was attracting some attention for similar reasons. People expected that the opportunities were pretty large in both. I think that perhaps the main factor is that we are talking about economic dynamics affecting the per capita income of people where there’s quite a lot of price elasticity.

So if the price of vehicles comes down a rather small amount, there are a very large number of people who suddenly can imagine purchasing a car. These are particularly people with some rising income levels of their own. The competition that causes the prices to drop and the other economic trends that are raising incomes can suddenly bring a large number of people over to what is sometimes called the motorization threshold. This is the point where people suddenly feel that they are able to buy a vehicle. I think that is probably the main thing.

Of course the outside investor interest in India has grown in recent years. People rushed first into China and then a little more slowly into India. But India then looked less crowded competitively, so that brought sort of a second rush. Perhaps the main constraint in this that has affected some of the investment, is that the infrastructure in India is really not adequate to take on a lot of new vehicles.

China governmentally at different levels has recognized this for a long time and they have been pouring huge amounts of money into new highways and other infrastructure. India has not. So we could have years of terrible, even worse congestion in India before that gets solved. But, my guess is that it might break some political logjams on the infrastructure side, if market growth continues.

Knowledge at Wharton: I’m sure that anybody who has driven in Bangalore would agree with you 100%.

MacDuffie: Yes.

Knowledge at Wharton: Looking at the big Japanese automakers — Toyota, Honda and Suzuki — all of them have been expanding capacity in India for the past few years. Could you comment on the strategies that these companies are adopting in India? And do you think that they ought to be focusing more on the domestic Indian market — which I believe, right now, is about 1 million cars sold a year but is projected to grow by 2012 to about 3 million cars. Should they focus on the domestic market or should they use India as a base to export cars to other markets?

MacDuffie: There’s a slightly different story about each of the companies that you mentioned. And you left out one that I think should be included which is Hyundai, the Korean Company. Suzuki has by now a pretty long history in India, having come in as a partner in Maruti which was half owned by the Indian government. And, partly because of that government investment and some other favorable regulations, Maruti at one time had a staggering 80% of the market, at the very small car end, and they really represented the first sort of modern automotive technology to come into India in some time. This was back now some 20-plus years.

The government has just in May of this year completed the selling of all of its ownership of Maruti. Suzuki now has a controlling 54% share. Suzuki has poured a lot of new investment into the Maruti plants and into expanding the Maruti product line. The classic automotive models like the Ambassador are perhaps a historical legacy in India. They often had very long lives because it wasn’t easy to replace them and you could get them repaired any place in the country. There was a huge amount of expertise, spare parts and the like.

Maruti is starting to benefit from the same thing; If you’ve got a Maruti, you can get it repaired anywhere and you can keep it on the road for a long time. Suzuki is going to try to take advantage of all of that head start lead that they have. Toyota came in much more recently and decided initially not to come in at the very low end of the market, but at a slightly higher end. My sense is that they slightly misgauged how much demand there would be at that level. The product didn’t sell as well as expected, although they have gotten some valuable experience there.

They, just like everybody, are trying to find just the right low cost car to bring into India to catch some of this swelling demand. I think the other Japanese companies like Nissan are in not terribly different situations. Honda generally comes into every country with motorcycles first, so that’s where more of their Indian investment has been, but they’re also aiming to grow.

Hyundai is the real surprise. They came in relatively [recently] and built a plant that was almost an exact duplicate of a plant in Korea. This included lots of automation, which you wouldn’t expect. They made the Sonata, which is a fairly mid-sized upscale car. But they also then brought in some small cars and managed to bring the price point down enough so that they have had really spectacular growth. And they have done some savvy things with their marketing to align their products with some iconic Indian images and people. In a way, they are the biggest success story of all of the newcomers in the Indian market and they are going to be tough competitors.

Knowledge at Wharton: Last month, Toyota’s chairman, Fujio Cho, was in New Delhi and he said that in the next couple of years Toyota is planning to launch a new small car. They considered a lot of different countries, but he did say that India might well be the first country where they launch it. Now, given everything that you just said about Suzuki and the popularity of the Maruti in India, do you think that Toyota will be able to take on Suzuki in the Indian market? And if so, what should their strategy be?

MacDuffie: Toyota is a very able competitor, as we all know. Overtaking Suzuki and let’s say Hyundai, as the most successful newcomer, probably depends on, first of all, getting the product right. Toyota had rather slow sales in Europe for quite a number of years, in which they mostly took models that were world models sold also in Japan. When they finally focused design effort and actually set up a design studio in Europe and produced a small car just for the European market, they suddenly started to take hold. They were doing lots of other things at the same time.

I would assume that they have India in mind as the first place that their design efforts are very much focused on consumer acceptance. That will be necessary from a styling and feature point of view, but probably price point will be the most important. Everybody is trying to innovate in every possible way to get the price point low enough.

Some of that involves the re-use of components from other vehicles; some of it involves judicious decisions about where you can cut back on lighter weight steel, and what paint jobs [you can use] that aren’t based on dealing with road salt in the northeast U.S. It’s the creativity to get the right mix of those kinds of cost cutting moves. I expect that Toyota will be very good at that and a lot of other companies will be trying.

If you have the right product at the right price point — then I think the Toyota advantages of a strong brand will kick in very strongly. Now again, Maruti has been perhaps a bit of a national favorite. Although, people know of course, that Suzuki is behind Maruti. Probably Tata, as Tata becomes stronger, will be even more the national pride purchase for an Indian consumer.

The Hyundai example again suggests that right product and right price, smart marketing and moving quickly are the key. Perhaps I will just say that Toyota is often a bit cautious and careful. And if speed does end up mattering, that may slow them down. But they have a tremendous track record for steady improvement and learning from their mistakes better than almost anybody. I think that if we look out five to ten years, we can expect Toyota to be strong

Knowledge at Wharton: I’d just like to end with a question about China. There have been news reports about a car price war in China that’s eating into the profits of companies like GM, VW, Hyundai, as well as China’s own auto manufacturers. This is obviously good for consumers. What are the implications for the companies and could this type of price war occur in other countries, or is China unique?

MacDuffie: That is a fairly familiar pattern of a gold rush mentality in which a very rapidly growing and promising market, first of all, provides phenomenal returns to some of the first movers who get in and start to establish a dominant position. Often that advantage does lag for a while, even when other newcomers come in.

But everybody is benefiting and at a certain point, even with rapidly growing markets, it’s suddenly a crowded market place. Then the price competition starts to erode things. Sometimes those that have made the least commitment will actually back out of markets. This was a story in Brazil, for example, in the mid 1990s, when there was also a lot of turbulence in government regulation and tax policy which heavily affected those trends.

The consumer credit picture in China has jumped around a bit and that’s affected demand. But … nobody is going to leave China. It’s too big and important. Everybody is going to want to hold on to a piece of that market rather than concede it to the Chinese domestic companies that are coming on strong.

I think everybody believes that there are things to learn from the pursuit of these low cost cars that can apply to a lot of the rest of their business. So, both in China and in India there are incentives to stay in that game. It wouldn’t surprise me if, in a few years, the same phenomenon is showing up in India for a similar reason.