Britain’s exit from the EU raises questions on the competitiveness of UK auto manufacturing in the long run given the intertwined nature of both the outbound and inbound logistics supporting the UK automotive industry.
With the UK triggering Article 50, IHS Markit Supplier Solutions team has completed an assessment of the impact on OEM sourcing strategies and possible trade policies that the UK government would need to implement in order to retain the competitiveness of UK manufacturing.
Increasing reliance on EU imports
The UK trade balance remains negative for finished vehicles, with the UK importing twice as many cars as it exported in 2016, 2.6 million vs. 1.3 million according to IHS Markit data.
The trade deficit is even worse for auto parts, importing nearly three times as much as it exports, which provides a glimpse into how reliant UK-based OEMs and tier-1 suppliers are on non-UK supplies.
This also corroborates the importance of a strong UK domestic supply base for the long-term competitiveness of UK car manufacturing, especially in the event of an ungracious exit from the European Union.
Local content for many UK based OEMs remains painfully low, mostly due to the efficient and well integrated supply base UK-based manufacturers can tap at their doorstep in both Western and Eastern Europe. An IHS Markit assessment of more than 100 critical components representing about 40 percent of the vehicle cost shows that local content levels for UK-based OEMs in 2016 are about 34 percent on average, meaning that 66 percent of the value of these components is being sourced from outside of the UK.
Some manufacturers sourced as little as 22-23 percent of these components in value from local UK-based suppliers. Despite OEMs’ efforts to strengthen the local supply base in recent years, the reliance on sourcing from the European Union has grown by an average of 1.3 percent a year in pound terms between 2011 and 2015, while UK production volumes have increased by 1.1 percent annually over the same period, and parts exports from the UK into the European Union have stagnated.
The integration, convenience and cost effectiveness of the European supply base for UK-based OEMs as well as major tier-1 suppliers is a major driver behind this growth of EU parts imports into the UK.
The European Union accounted for about 73 percent of the overall parts import bill back in 2011 (about £10.2 billion), later increased to 79 percent by the end of 2015. This is linked to the sourcing strategies that carmakers have been pursuing.
For example, Japanese carmakers have been aiming to increase localization in Europe and other regions in order to develop a currency hedge and reduce the long supply pipelines and over-reliance on single sources in Japan, exposing several weaknesses due to yen exchange rate fluctuations as well as the 2011 tsunami supply chain disruption.
This strategy has also been pursued by UK-based OEMs, particularly Toyota and Honda, and has indeed resulted in a reduction of imports of parts from Japan into the UK. Japan was the second import source of UK-bound parts in 2011 with £1.4 billion, after Germany with £3 billion.
Imports from Japan were reduced to £0.4 billion at the end of 2015. The re-shoring of parts in the European region did not actually result in an significant increase of localization in the UK, but rather in increased sourcing from other European Union countries, mostly Central and Eastern European countries which increased exports to the UK by £580 million per year to the point where Italy, which was UK’s third largest parts import source in 2015 after Germany and France is likely to be replaced by Poland with over £500 million of exports to the UK. Germany, the major trading partner has recorded similar import values between 2011 and 2015.
Supply chain weaknesses
Sourcing structures and local vs. import decision making varies greatly by system. For example, about 61 percent of the engines installed in UK-produced cars are locally assembled, an increase of 15 percentage points compared to 2011, however only about 1 percent of the transmissions for UK vehicles are manufactured locally, with the vast majority coming from Germany, Japan and Spain.
At a subsystem level, major gaps in the offerings of local suppliers emerge in the area of headlamps, central body control modules, wiring harnesses, steering systems, turbochargers and fuel injectors as well as emission control technologies.
Failure to implement a free trade agreement with the European Union following a “hard Brexit” would mean tariffs between three and 4.5 percent would be imposed upon import.
This is enough to wipe out the margin that suppliers build into their pricing for several components in the vehicle, forcing them to increase their prices to OEMs.
The advent of Brexit will therefore provide momentum to OEMs’ efforts to source more locally in order to reduce exposure to eventual tariffs, as well as to create a natural hedge against currency fluctuations by creating a cost structure for UK-built vehicles more in pounds rather than Euros.
Supporting the development of a local supply base
Technology availability and bias from OEMs, as well as cost considerations are likely to create major hurdles to the development of the local supply base, at least initially. Increasing local sourcing in a “hard Brexit” scenario, where the UK-Europe trade flows would be regulated under WTO tariff schemes, would likely require a strong commitment from both OEMs and the British government in order to develop the local supply base.
OEM investments resulting in substantial increases of production volumes in the UK would certainly accelerate localization and reduce the impact of tariffs and the logistical challenges of having a customs barrier.
Several suppliers have indicated that the achievement of scale of production for UK-based automakers would create a natural draw to investing in the UK and therefore ensure the development of a stronger UK supply base.
While several OEMs have announced their commitments to UK production, most recently Toyota which pledged £240 million to upgrade its UK facilities, this does not seem to be enough to attract new suppliers to the country. Few suppliers felt confident that the vehicle production scale would be able without significant investments from the OEMs resulting in more appealing RFQs for the supply base.
Moreover, the scale of production largely depends on the component sector. For example, the production level that would potentially trigger the investment from a radiator supplier is about 600,000 vehicle units, while an investment from a shock absorber supplier is unlikely to materialize unless the supplier has a business of about 800,000 vehicles secured via one or several customers in the same region.
Even an unlikely growth of production volumes by more than 50 percent over 2016 levels (1.8 million units) would not be enough to justify the investment business case for several suppliers as some business opportunities will be difficult to achieve given the inherently diversified sourcing structures that UK-based manufacturers have historically pursued with.
For example, Toyota and Honda are still leveraging some suppliers with strong ties to Japanese OEMs that have not gained much business with other UK domestic OEMs.
The government can support OEM and supplier investment to increase localization in several ways. For example by applying auto-specific corporate tax rates or setting up Special Economic Zones with attractive taxation rates.
However any of these options is unlikely to be cheap or easy to implement. For example, a substantial corporation rate cut to make UK manufacturing more appealing for OEMs, from 20 percent to 10 percent for example, to sweeten the impact of a “hard Brexit” would have cost £130 million in lost tax revenues in 2016 for Jaguar Land Rover alone. This amount is about half of what the UK government spends each year on local roads.
Supporting UK exports
A well-established practice in several countries is the duty drawback scheme, which would be appreciated by OEMs and exporters in general, as it would help them retain the export competiveness in the scenario of a fall back to WTO rules. Under a duty drawback scheme, OEMs would be able to claim back the duties paid to import parts into UK for cars which are later exported. If, for example, this measure had been implemented in 2015 and limited only to EU parts imports later re-exported to EU as finished vehicles, about £6 billion per year would be covered under the scheme.
The UK Treasury would have had to reimburse some £240 million per year to OEMs, which is the equivalent to two days of interest payments of UK’s public debt or the annual expenditure on local roads.
While the figure might be slightly lower due to some India and China sourcing replacing eastern European sourcing into the UK, the cost of this measure, as well as the red tape element associated with its enforcement for rules of origin, proof of exports etc, represent major hurdles.
It would also be likely to result in WTO level disputes; for example, if it allows the OEMs to circumvent duties. A hypothetical case could involve OEMs sourcing radios from China into the UK (which carry a 14 percent duty), then exporting that car into Europe, which would allow the OEM to claim back the duty.
Moreover, it would also have a perverse effect on localization, as the less an OEM has localized, the more it will benefit from this measure. This would be hard to justify for the UK government, which has the objective to reinvigorate the UK’s industrial prowess.
There is little surprise that all stakeholders of UK’s automotive industry are concerned about the trade terms between the UK government and the European Union.
The impact of Brexit would be pretty minimal from a cost or supply chain restructuring perspective should the UK manage to retain a form of free trade access and regulation alignment with the EU, which seems unlikely at this stage.
In a “mild Brexit” scenario, with the UK leaving the EU customs union while retaining some form of special tariff treatment for the automotive sector, OEMs would need to re-design their supply chains to account for the logistical inefficiencies generated by the presence of a customs filter.
This will entail higher parts inventories, resulting in a moderate cost increase. In the event of a “hard Brexit”, many UK car plants will find themselves at a competitive disadvantage vis-à-vis their continental counterparts from a cost and logistics perspective, for some this might not result in a change of commitment to UK manufacturing, for example premium manufacturers like Jaguar Land Rover or Bentley, but other more volume players may think otherwise.
While both OEMs and suppliers will try to attract more suppliers to localize production in the UK, it seems unlikely that enough suppliers would pursue an investment in the UK due to the lack of scale, unless lured by significant concessions.
Therefore the reliance on the European Union for parts imports is unlikely to disappear even in a “hard Brexit” scenario, while input cost creep would materialize due to tariffs and logistics.
In the event of no government concession and with some investment in increasing local content, we estimate these add on costs to be on average of 2.5 percent, however these would vary depending on the OEM.
Such an increase is likely to be passed on to consumers in line with price adjustments that several OEMs have imposed to UK consumers following the sterling devaluation against the Euro and the dollar after the June 2016 referendum. Should that be the case, a Nissan Qashqai 1.5 Diesel, the UK’s best-selling domestic vehicle, would need to cost on average of £600 more.
However falling back to WTO terms would result in a 9.9 percent tariff on imported vehicles, making them much more expensive and less competitive on the UK market. Manufacturers like Volkswagen and PSA combined with GM which have imported 566,000 and 466,000 vehicles respectively in 2016 would face tariff bills which could justify investing in a plant in the UK.
The definition of the trade details between UK and the European Union remains therefore key to defining the future of the auto manufacturing landscape in the UK.