The Brazilian auto industry will finish the current year with record high production volume of 2,450,000 vehicles, an 11% increase over 2004, according to ANFAVEA, the national association of automobile manufacturers. Success is largely due to a 29% increase in exports — historic numbers that contrast with growth in domestic sales of barely 5%. Nevertheless, not everything is going well for automakers. Analysts predict that 2006 will be full of challenges due to the rising value of the Brazilian real, which is making it harder to sell in foreign markets. In addition, the domestic market is hobbled by one of the world’s highest interest rates (18.5%). Forecasters do not expect economic growth to be strong enough to generate many new jobs or to raise the population’s ability to purchase big ticket items like cars. In short, while the auto industry has some reasons to celebrate, it is also casting a wary eye on the future.

A $26.6 Billion Investment

The Brazilian auto industry has done well in 2005, recording production volume so far of about 2,210,000 vehicles. The previous record of 2,070,000 vehicles was reached in 1997, but shattered this year largely because 790,000 vehicles were shipped to foreign markets.

What factors are responsible for the success of Brazilian-made cars in such places as Argentina, the United States, Mexico, the European Union, the Andean countries, Chile and elsewhere? According to Rogelio Golfarb, president of ANFAVEA and director of corporate affairs and communications at Ford Motor Company’s subsidiary in Brazil, “The increase in Brazilian auto exports stems from the $26.6 billion invested in the sector between 1994 and 2004 (by assembly plants and component manufacturers) that modernized and expanded plant capacity.”

A large part of these investments “involved new technology and the development of new models,” he adds. This money, along with marketing campaigns by the companies and the rising competitiveness of Brazilian auto products, made it possible to increase exports, which rose from about $4 billion in 2002 to what is expected to be $10.8 billion in 2005.

Experts say that another key factor was the devaluation of the real, the Brazilian currency, throughout most of 2004 and 2005. Sandro Maskio, an economics professor at the Methodist University of São Paulo, suggests that what differentiates Brazil in export markets “is the attractiveness of its currency…. It helps our exports, and makes it easier to place made-in-Brazil products at favorable prices in foreign markets.”

But Sergio Buarque de Hollanda Filho, an economist at FEA-USP (the economics and management department of The University of São Paulo) sounds a cautionary note. “For quite some time, the real has been gaining value, and that clearly makes exports more difficult.” Conditions for the Brazilian currency changed during 2005, Buarque notes, and it is now over-valued.

Most experts agree with Buarque that the appreciation of the real, relative to the dollar and the euro, could begin to hurt the Brazilian auto industry. The closer the real gets to the dollar (it currently takes 2.30 reais to buy one dollar), the less profitable exports will be for Brazilian vehicle assembly plants, and the less interest there will be in centralizing global production in Brazilian-based factories. This could eventually mean that multinationals in Brazil decide to transfer part of their production volume to other subsidiaries that are more competitive because their costs are lower.

Nevertheless, Maskio does not believe there is a short-term danger of assembly plants relocating to other countries. In his view, the main attraction of Eastern Europe, where vehicle makers from the European Union are now moving, is its cheap cost of labor. That’s something Brazil already has. And while some South American countries can offer automakers production costs that are much lower than Brazil’s, these countries “have other problems, including political insecurity, as in the case of Bolivia and Venezuela, and economic insecurity, as in the case of Argentina.” Nor should Brazilians be worried about Mexico, he adds. “In order to manufacture vehicles in Mexico and transport them to South America, Mexico would need a much greater cost advantage — enough to overcome the extra transportation” expense.

However, Maskio does see some long-term danger from high taxes and labor costs in Brazil. He says the government has tried to enact a measure that would reduce taxes on the manufacturing process, but adds that this reform effort is currently on hold. “The trend is for the gap in competitiveness (with neighboring countries) to become smaller and smaller. This means that as soon as other countries gain a competitive advantage, multinationals could decide to relocate.”

A Weak Domestic Market

Meanwhile, the volume of domestic sales in Brazil has not grown as fast as the volume of exports. ANFAVEA labels the 5% increase over last year (1,660,000 units) as “vegetative growth.”

According to Golfarb, the major obstacles to domestic sales are high interest rates, which discourage people from borrowing to buy new cars, and extremely high taxes on cars themselves. In addition, per capita income has dropped, a recurrent phenomenon in recent years. Although 2005 has seen a mild improvement in conditions for Brazilians, this has not translated into a notable increase in the sale of big ticket items, like cars.

The factors that inhibit the domestic market depend on policies carried out by the Brazilian government, and yet, says Maskio, President Luiz Iacio Lula da Silva and his advisors have not seemed inclined to enact any major change in economic policy. As a result, Maskio predicts that interest rates will remain at the same high levels in 2006, a presidential election year. He also expects that Brazilian income levels will not improve significantly, at least in the coming year.

Buarque agrees. “In the domestic market, so long as interest rates continue to be high, it will be hard to generate additional investment and develop new ways for consumers to finance their purchases. Growth in Brazil will be slow [analysts expect the GDP to increase by between 2.5% and 3.5%], and there will clearly be a limit to sales growth in the domestic market.”

The Outlook for Exports

As experts note, the market for exports is closely tied to the government’s monetary policy, which isn’t likely to change either. Consequently, Maskio believes that “the only way the export market could improve would be for stronger behavior by the Central Bank in the foreign exchange market. It would mean raising the value of the dollar a bit more and, that way, providing incentives for exporting firms. Through exports, the government could improve” the outlook for auto dealers as well as auto suppliers.

But so far, he adds, “the government has given no sign that it will take that approach. It is has tried to intervene in the exchange market to prevent the real from falling below 2.30 reais [to the dollar], but it has not given any evidence that it is going to intervene more strongly so that the rate returns to between 2.60 and 2.70 reais to the dollar, the way it was before …. Conditions will continue more or less unchanged. And because it is an election year, the government must give priority to inflation,” which suggests that officials will shy away from any drastic or “bold changes in economic policy.”

Another factor that could stimulate Brazilian car exports is the new agreement for free trade in vehicles between Argentina and Brazil, scheduled to be enacted in 2006. The agreement would make it easier for Brazilian cars to enter Argentina. Buarque, however, says that there is little likelihood of this actually happening. “In principle, at the start of the new year, trade in this sector should be free — free of tariffs between Argentina and Brazil because of the pact in the auto sector. But it is not very likely that this will happen” because exports from Brazil are growing at a strong rate, and because Argentina will probably not be ready to accept free trade as early as next year.

Reasons for optimism in the auto industry remain — including record high production and the strong performance of the export sector. At the same time, prospects for the near future are not very promising. Brazil’s auto sector should keep the champagne corked, at least for the moment.