Wharton's John Paul MacDuffie and U.K. auto expert David Bailey see a bumpy road ahead for the U.K.'s auto industry.

The British auto industry today is facing one of its worst crises ever thanks to declining car sales and the uncertainty over Brexit. Global automakers have put off or canceled fresh investments, and invested instead in cheaper locations like Slovakia, while at the same time shutdowns or relocations of existing plants are imminent, according to experts.

Layoffs have already begun in the industry, with the U.K.’s biggest automaker, Jaguar Land Rover, announcing 4,500 layoffs, or more than a tenth of its 40,000-strong workforce. The country’s auto industry at last count employed 860,000 people, which includes supporting segments such as repairs and financing, generated 82 billion pounds ($108 billion) in annual revenues and had an economic impact of $266 billion, according to data from the Society of Motor Manufacturers and Traders (SMMT), the trade body of the U.K. automotive industry.

“Car company executives are literally pulling their hair out, and in the state of disbelief that we are in, such political chaos in the U.K. has not been seen,” said David Bailey, professor of industrial strategy at Aston University’s business school in Birmingham, U.K. Bailey is also author of the new book Keeping the Wheels on the Road: U.K. Auto Post Brexit.

Bailey offered an example of how the uncertainty over Brexit is playing out for automakers. Visualize cars made in the U.K. and loaded onto ships headed for Japan or Korea. “The car companies don’t even know when they arrive whether or not they’ll face tariff barriers. At the moment, the U.K. benefits from an EU trade deal with Japan and Korea or other countries. If we fall out, we’ll no longer benefit from that.”

Automakers could also permanently move more and more of their production facilities to other countries that are not only cheaper, but also offer more stable business environments. “Auto companies are very global in their orientation — they have to be,” said John Paul MacDuffie, Wharton management professor and director of the Program on Vehicle and Mobility Innovation at Wharton’s Mack Institute of Innovation Management. “Free movement across borders of products, of components, of people is just hugely important to them. They’re well familiar with making investment decisions in different parts of the world and sometimes backing away from one or deciding to grow faster or some other place.”

If the business environment looks unfavorable in the U.K., automakers will simply move somewhere else, MacDuffie said. “It will not in the end have that big an impact on their overall global strategy, [although] they won’t necessarily be happy about having to do it,” he added. “But [there will be] consequences for the U.K. economy, for the people holding those very good jobs, and other multiplier effects that go out from the assembly plants into R&D and into suppliers. That’s the real potential loss here, and it’s huge.”

“Car company executives are literally pulling their hair out and in a state of disbelief that we are in such political chaos in the U.K.” –David Bailey

Bailey and MacDuffie discussed the implications of Brexit-related issues and other dampeners for the U.K. auto industry on the Knowledge at Wharton radio show on SiriusXM. (Listen to the podcast at the top of this page.)

Costs of a No-deal Brexit

If British premier Theresa May secures Parliament approval for a plan to remain in the EU customs union and common market, the exit date would be pushed to May 22. Further extensions are not ruled out if fresh elections or a second referendum on Brexit look likely, but a no-deal Brexit is “very likely,” the EU’s chief negotiator Michel Barnier said April 2, as May’s latest proposals failed to win support among MPs.

A no-deal Brexit would mean the U.K. would leave the EU on April 12, plunging its auto industry into a chaotic mess of sudden tariff walls and customs checks. “That would make a mess of very integrated just-in-time arrangements and supply chains across borders,” said Bailey. In the immediate short-term after Brexit, the auto industry could see an output fall of around 175,000 units a year, and if companies do not replace car models at the end of their life cycles, that number could swell by another half -million units by 2025, he added.

Those production falls would have large impacts on an industry that is already operating on thin margins, said Bailey. The U.K. auto industry could take a $3 billion revenue hit in the event of a no-deal Brexit, and that would be “pretty damaging,” he added. He noted that Jaguar Land Rover alone has forecast the potential hit from a no-deal Brexit at $1.58 billion a year. “Remember, that’s a loss-making company already – $1.58 billion a year [in revenue losses] will mean plant closures.”

Planning Around Brexit

The auto industry typically plans years in advance, and in the case of Brexit, its unease set in with the June 2016 referendum that came “without a plan and high uncertainty,” MacDuffie said. “The auto industry has a relatively slow clock speed. Think of a four-year product replacement cycle unlike what we’re used to with electronics and in IT.”

At the same time, “there is no upside from Brexit for the U.K. car industry,” said Bailey. Its worries are all over the extra costs and trade barriers that Brexit will mean. “Regardless of what happens, it will make making cars in the U.K. more difficult. For much of U.K. manufacturing, it’s about damage limitation.” The U.K. economy would take a sizable hit as auto exports account for nearly 13% of its total exports.

Honda’s decision to close its Swindon plant is essentially a verdict that the U.K. will not be “an attractive place” to make electric cars in the early 2020s, Bailey suggested. “That’s quite a big criticism of the British government’s industrial policy, which is all about making electric cars,” he said. Further, the new EU-Japan free trade agreement will help companies like Honda to make cars in Japan and export them to the EU increasingly without tariff barriers, he noted.

Bailey also pointed out that Jaguar Land Rover, which is owned by the Tata group of India, recently invested in a plant in Slovakia. “That investment was partly because they wanted to access lower labor costs in Slovakia, but it was also a hedge against Brexit. “We might see Jaguar Land Rover shifting more production to Slovakia to produce inside the Eurozone for that market.”

“Do you want to [invest in auto manufacturing] in the U.K. if you’re not going to be able to export freely to the EU?” –John Paul MacDuffie

Many U.K. automakers are temporarily closing their plants in April. Those include Jaguar Land Rover, BMW, Peugeot and Opel Vauxhall. In February, Honda said it would close its Swindon plant in 2021, but it attributed that move to a restructuring of its global operations, and not Brexit. That shutdown imperils 3,500 jobs at the plant. Nissan has canceled plans to build SUVs at its Sunderland plant, and Toyota said it could end U.K. production by 2023 in the event of a no-deal Brexit.

Many car makers are stockpiling components, because they don’t know whether the U.K. will still be in the EU customs union, Bailey noted. “In the extreme case, you’ve got niche producers like Aston Martin prepared to fly in high-end components to keep their production lines going,” he said. “But it’s difficult for the companies to be doing the things that they need to do, which is transforming their business models towards electrified and connected vehicles, when they don’t know whether they’ll be able to make the cars in the U.K. and export them to Europe without tariffs and non-tariff barriers.”

How U.K. Auto Lost Europe

The British auto industry closed 2018 with new car registrations declining 6.8% to 2.37 million units, of which diesel vehicles saw a nearly 30% drop, according to the SMMT. A trend of nine straight months of production losses worsened in the first two months of 2019. Auto exports too decline, with those to China falling nearly 56% – telling for an industry that exports more than 80% of all vehicles made. Investment in the U.K. auto industry has fallen 80% in the last three years, and it has lost 10,000 jobs in the last two years, Bailey wrote in a recent article.

Bailey noted that the U.K. auto industry has lost out on the progress achieved since the 1980s, when British Prime Minister Margaret Thatcher attracted Japanese car companies to invest in the country. Companies like Honda and Nissan invested in the U.K. as a base to export to Europe, which over time has accounted for more than half of British car exports. MacDuffie agreed with Bailey and said that “the success back in the 1980s of attracting the Japanese companies to make the U.K. their beachhead or production base for all of Europe was a huge achievement.”

However, the EU market also has shrunk, and U.K. car exports to Europe fell 15% in the first two months of this year. “The likes of Honda that came here are scratching their heads, thinking ‘what on earth is the U.K. doing?’ ” Bailey said, referring to the Brexit uncertainty.

Broader Changes

Brexit, of course, is not the only culprit behind all those woes. Bailey pointed to two other factors. One is “a huge shift” away from diesel cars. The second is the impact of an economic downturn in China.

MacDuffie noted that diesel vehicles have lost market share because they are being perceived “as not being green and clean, but being dirty and having major net negative health consequences.” European companies are now pushing to make electric vehicles, but consumers are responding “a little slower” to pick up that trend, he said. China happens to be the biggest market for electric vehicles, but demand from consumers is running slowly there as well, he added.

Broader changes in consumer preferences are also having an impact on British car exports. “The industry is about to transform itself, particularly in Europe, where a big shift towards electric cars is coming and autonomous cars in the future,” said Bailey.

Against those broader market shifts, the uncertainty over Brexit “just complicates decisions about where to put that investment in electric vehicles,” MacDuffie said. “Do you want to [invest in auto manufacturing] in the U.K. if you’re not going to be able to export freely to the EU?”

Bailey and MacDuffie cited the decline of auto manufacturing in Australia as an example of how global automakers exit unhelpful markets. “[The Australian experience] has to scare anyone in the U.K. who understands how important the auto industry has been to the manufacturing sector and the overall economy since the 1980s,” MacDuffie said.

Seventy years of auto manufacturing in Australia came to a screeching halt in 2013 and 2014 when Ford, General Motors-Holden, Mitsubishi and Toyota stopped manufacturing in the country, wrote Alex de Ruyter, professor and director at the Centre for Brexit Studies at Birmingham City University, in a chapter in the book Keeping the Wheels on the Road: U.K. Auto Post Brexit. “The Australian experience points to the primacy of the state as fostering industry policy and industrialization,” he noted.