CMER Working Paper Series

Working Paper No. 97-15

AUTOMOBILE DELETION POLICY: AN ANALYSIS

By Dr. Jawaid A. Ghani

OCTOBER 1997

CENTRE FOR MANAGEMENT AND ECONOMIC RESEARCH Lahore University of Management Sciences
Opp. Sector U, DHA, Lahore Cantt. 54792, Lahore, Pakistan Tel.: 92-42-5722670-79, x4222, 4201 Fax: 92-42-5722591 Website: www.lums.edu.pk/cmer

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TABLE OF CONTENTS
1. INTRODUCTION.................................................................................................................................................... 3 2. EFFECTIVE PROTECTION RATES...................................................................................................................... 4 3. ESTIMATED REVENUE BREAKDOWN............................................................................................................... 5 3.1 ASSUMPTIONS...................................................................................................................................................... 8 3.2 FOREIGN MANUFACTURING ............................................................................................................ '.................. 9 3.3 LOCAL MANUFACTURING.................................................................................................................................. 9 3.4 GOVERNMENT TARIFF REVENUE...................................................................................................................... 9 3.5 REVENUE TO LOCAL ASSEMBLER .................................................................................................................... 9 3.6 SUBSIDY AVAILABLE TO LOCAL MANUFACTURING...................................................................................... 9 4. POLICY MEASURES.............................................................................................................................................10 4.1 REDUCTION IN CBU TARIFFS ............................................................................................................................10 4.2 IMPORT OF USED CARS .....................................................................................................................................10 4.3 REDUCTION IN RAW MATERIAL TARIFFS .......................................................................................................10 4.4 VENDOR DEVELOPMENT FUND.......................................................................................................................11 4.5 IMPLEMENTATION OF DELETION POLICY.......................................................................................................12 5. LOCAL MANUFACTURING CAPABILITY......................................................................................................... 12

LIST OF TABLES AND FIGURES

TABLE 1: EFFECTIVE PROTECTION TO AUTO INDUSTRY ...................................................................................................... 4 TABLE 2: REVENUE BREAKDOWN FOR 1500CCCAR ........................................................................................................... 6 TABLE 3: ESTIMATED SUBSIDY PROVIDED TO AUTO ASSEMBLERS (1996-97) ...................................................................... 8 TABLE 4: DELETION LEVELS (800 cc CAR)...................................................................................................................... 14 TABLE 5: DELETION LEVELS (1500 cc CAR).................................................................................................................... 14 FIGURE 1:EPR AT DIFFERENT DELETION LEVELS .............................................................................................................. 5 FIGURE 2: REVENUE BREAK-DOWN BY STAKEHOLDER ....................................................................................................... 6 FIGURE 3: MANUFACTURING COST BREAKDOWN FOR 800 cc CAR .....................................................................................13

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1. INTRODUCTION
This paper estimates the protection provided to the automobile industry, and discusses various policy measures. A discussion of the following issues is presented:

1. Effective protection rates being provided to different segments of the automobile industry.

2. Analysis of protection in terms of revenue break-down. These figures estimate the revenue going to different stakeholders at different levels of deletion. The revenue is provided by the consumer. It goes to: cost of foreign manufacturing cost of local manufacturing (both local OEMs and vendors) subsidy to local manufacturing (mostly to local OEMs) government as tax revenues (I have only considered tariff revenues)

The various assumptions while making these calculations are also listed.

3. Policy measures. These are discussed in terms of the net effect on each of the stakeholders. The options considered are: reduction in CBU duty rates allowing import of used cars at reduced CBU duty rates reduction in raw material duty rates redistributing a portion of the subsidy to a vendor development fund strengthening the implementation of the deletion policy

4. Local manufacturing capability. This is discussed by presenting a break-down of manufacturing costs by major component. Deletion plans are discussed in terms of percentage of major automobile components being locally manufactured and the percentage which is planned to be located manufactured in the next five years.

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2. EFFECTIVE PROTECTION RATES

The levels of protection provided to auto assemblers are very high. The following table shows the effective protection rate (EPR) for various segments of the industry.

Table 1: Effective Protection to Auto Industry IMPORT % CKD/ RM 1500 CC 800 CC TRACTOR VENDOR using S-FORM without S-FORM without S-FORM and competing against smuggled items 70% 40% 20% TARIFF CBU 150% 110% 35% TARIFF CKD/ RM 32% 32% 32% EPR

425% 162% 36%

30% 30% 30%

45% 45% 20%

20% 65% 65%

56% 36% 1%

EPR can be considered as the ratio of implicit subsidy provided (to local manufacturing) to the cost of local manufacturing (assuming international levels of efficiency), i.e.,

Implicit subsidy to local manufacturing Fair cost of local manufacturing

Thus a local plant making 1500 cc cars is being provided a subsidy which is 4.25 times the amount it would cost to manufacture internationally. In other words local manufacturing can be 5.25 more expensive (inefficient) compared to international standards, and yet remain profitable. This can be

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understood somewhat more clearly by examining the level of subsidy provided to local manufacturing at different levels of deletion.

Figure 1: EPR at Different Deletion Levels

3. ESTIMATED REVENUE BREAKDOWN

In order to understand the nature of protection provided to local manufacturing it is useful to examine the revenues which go to various stakeholders on the sale of a car. The estimated revenue breakdown at different levels of deletion for a 1500 cc car is shown in Figure 2 and Table 2.

The detailed formulas and assumptions are listed separately below. Thus the international price is taken as $100, the local price is taken as equal to the duty-paid price of an equivalent imported car, CBU duty is taken as 150%, and CKD duty as 32%.

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Figure 2: Revenue Break-down by Stakeholder

Table 2: Revenue Breakdown for 1500 cc car Deletion Percentage 0 10 20 30 40 50 60 70 80 90 100 The subsidy is: { Revenues obtained by the local car assembler } minus {cost of foreign manufacturing + fair cost of local manufacturing + amount paid as government import tariff} Foreign Mfg 100 90 80 70 60 50 40 30 20 10 0 Local Mfg 0 10 20 30 40 50 60 70 80 90 100 Tariff Company Revenues Revenues 32 250 29 250 26 250 22 250 19 250 16 250 13 250 10 250 6 250 3 250 0 250 Implicit Subsidy 118 121 124 128 131 134 137 140 144 147 150

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According to the above analysis the subsidy increases as deletion levels increase. In reality this is probably not the case since local manufacturing is probably considerably less efficient than foreign manufacturing. Thus the slope of local manufacturing is far more steeper than the above estimates would suggest. That is, at 100% deletion the cost of local manufacturing will not be $100 (the international cost) but rather maybe $150 or even $200. As a result of a steeper local manufacturing slope, the subsidy decreases as deletion levels increase, thus discouraging assemblers to manufacture locally (and resisting attempts to enforce the deletion policy). The policy implication (which will be discussed later) is that efforts need to be made to bring down the cost of local manufacturing. This could be done through redistributing the subsidy from the auto assemblers to a vendor development fund and also by bring tariffs on raw materials down.

Table 3 estimates the subsidy provided to various auto assemblers. A key assumption is that the price being charged is equal to the duty-paid price of an equivalent imported car1. This subsidy is a net transfer from consumers to local manufacturing. There is considerable evidence that most of this subsidy is captured as economic rent by the auto assemblers (rather than by auto vendors) due to the greater bargaining power of the former over the latter and due to the weak enforcement of the deletion policy by the government.

It is suggested that the Engineering Development Board obtain estimates of international prices of equivalent cars, in order to make more accurate estimates of subsidy.

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Table 3: Estimated Subsidy Provided to Auto Assemblers (1996-97) COMPANY REVENUES (Rs. million) 7,904 2,794 4,136 14,834 COST AT INTL LEVELS 3,764 1,118 1,654 6,536 % DELETION 50% 30% 33% GOVT REVENUES 602 250 355 1,207 SUBSIDY

PAK SUZUKI HONDA INDUS (Toyota) TOTAL

Note:

3,538

1,426 2,127 7,091

Revenue figures are taken from published company annual reports Int'l cost levels are calculated as [Revenue/(1+ CBU duty)] Deletion for Pak Suzuki is approximated as the average of 61% (Mehran) and 36% (Margalla) Government tariff revenues are [%import x CKD duty x Intl cost level] Subsidy is calculated as [(Company Revenue) -(Intl cost + Govt tax revenue)]

3.1 ASSUMPTIONS
1. For the sake of illustration the international price of a completely built unit (CBU) is taken to be $100. 2. In order to make a meaningful measure of subsidy, the fair cost of local manufacturing is estimated. This assumes that the level of efficiency (cost effectiveness) of local manufacturing is at par with international levels. In reality local costs may be higher (due to low scale economies) or lower (due to lower labour costs). 3. Only government tariff revenue is considered in order to simplify calculations. Several of the new OEMs are able to avail tax holidays, while the older ones have accumulated tax loss carryovers, which results in minimal income tax revenues . 4. Sales tax is not considered in order to simplify calculations. Since GST is adjusted and the consumer pays the same amount irrespective of level of deletion, the estimates should not be affected. 5. Import tariffs on CKD are taken as 32%. Import tariffs on CBU are taken as 110% for cars less than lOOOcc, 120% on 1000-1300 cc cars, and 150% on 1301-1800 cc cars.

Total taxes paid by Pak Suzuki, Honda, and Indus Motors in 1995-96 was Rs 217 million on sales of Rs. 14.8 billion, i.e., 1.5 percent.

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3.2 FOREIGN MANUFACTURING FM = ($100) x (% imported) If deletion is zero then FM is $100; if deletion is 100 percent then FM is zero 3.3 LOCAL MANUFACTURING LM= ($100) x(% deleted) If deletion is zero then LM is zero; if deletion is 100 percent then LM is $100 3.4 GOVERNMENT TARIFF REVENUE TAX = ($100) x (%imported) x (CKD duty rate) If deletion is zero then TAX is $32; if deletion is 100 percent then TAX is zero 3.5 REVENUE TO LOCAL ASSEMBLER REVENUE = (S100) x (1 + CBU duty rate) The maximum price which can be charged for an car produced locally is the duty paid price of an equivalent imported car. Thus REVENUE is $250 for a 1500 cc car and $220 for a 1000 cc car (with duty rates of 150% and 120% respectively). 3.6 SUBSIDY AVAILABLE TO LOCAL MANUFACTURING SUBSIDY = REVENUE - (FM + LM + TAX) = [$100] x [(CBU duty rate - (%imported) x (CKD duty rate)] For a 1500 cc car with zero deletion SUBSIDY is $118. With 100% deletion the SUBSIDY is $150.

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4. POLICY MEASURES
4.1 REDUCTION IN CBU TARIFFS CBU tariff levels could be decreased from the existing high levels. This would bring down the price of duty-paid imported cars, thus directly bringing down the price ceiling for local cars, i.e., the maximum price which can be charged. This increases consumer welfare, and decreases the subsidy available to local assemblers.

This step would adversely affect existing investments, i.e., plants which have already been set up assuming that previous protection levels would continue. Before pursuing this policy option it is important that the cost structure of existing manufacturing capabilities for different car segments and components be thoroughly examined by the Engineering Development Board. 4.2 IMPORT OF USED CARS This involves permitting the import of used cars and allowing for a depreciation allowance on the price of the car. In effect this decreases the CBU tariff rates applied to used car imports.

The availability of used cars would have a substitution effect on new car sales. It is expected that new car sales will thus go down, resulting in further decreasing scale economies to local manufacturing and thus increasing the cost of local manufacturing. Since there is no system for certifying the condition of the imported used cars, consumers might lose out through the sale of lemons. Consumers might end up providing a subsidy to car traders.

In order to properly analyze this policy option it is necessary to have demand cross-elasticities available (to understand how consumer purchase behaviour would change if used cars were available) and also to understand the effect of volume on local manufacturing costs.

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4.3 REDUCTION IN RAW MATERIAL TARIFFS A decrease in raw material import duties would decrease the cost of local manufacturing. This would encourage assemblers to increase the level of deletion voluntarily (rather than just through monitoring by government agencies).

Local manufacturers can obtain concessions on import duties in raw material imports provided they use the S-form. However there is evidence that the vast majority of automobile vendors are unable to avail this facility3. As a result they often buy small quantities of expensive raw materials from traders (who make bulk import purchase paying the full import duty rates). Alternatively they sacrifice quality by purchasing inferior quality raw material.

A decrease in raw material import duties would not only make the vendor industry competitive for supplying to OEMs (thereby increasing deletion levels) but also increase the share of local manufacturing in the large replacement market and also encourage exports. 4.4 VENDOR DEVELOPMENT FUND A percentage of the subsidy available to local assemblers could be put into a vendor development fund. This fund would help in bringing down the cost of local manufacturing by providing technology transfer, quality control, and training facilities. The net effect would be that the subsidy would be redistributed, and assemblers would be willing to increase the level of deletion due to a more competitive local vendor industry. This policy would be consistent with the actual purpose of the large protection being given to the auto industry, i.e., to contribute to developing the technological base of the country. The experience of

A survey of auto vendors conducted in December 1996 indicated that less than 10 percent of vendors use the S-form for purchasing raw materials. See J. Ghani, "Vertical inter-firm linkages in the Pakistan automotive industry", CMER Working Paper, Lahore University of Management Sciences, April 1997.
4

It is estimated that the size of the replacement market (for cars and all commercial vehicles) is worth Rs. 60 billion. This is thrice the size of the OEM market. Unfortunately extensive smuggling has resulted in a reduction of local manufacturing share from 40 to 20 percent during the last few years. Note that this is the segment which receives the least protection due to high cost of raw material (due to not using S-form) and minimal barriers to smuggling.

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several industrializing and industrialized countries suggests that a strong technological base results in positive externalities to the rest of the economy through skill development and a variety of spin-off effects. Once adequate scale economies are achieved (usually through long-term supply arrangements with large OEMs), vendors are able to diversify into other engineering goods for the local and the export markets.

In order to effectively manage the vendor development fund it is necessary that current technological capabilities available in the country be understood. The deletion plans of different assemblers need to be coordinated with the plans for technological upgradation by vendors. The role of the Engineering Development Board would be to ensure transparency and proper coordination as part of a long-term plan for enhancing the technological base of the country. 4.5 IMPLEMENTATION OF DELETION POLICY An effectively implemented deletion can indeed result in the kind of positive externalities discussed above . A good example is the tractor industry whereby a large cluster of vendors were developed in a short period of time during the eighties. As a result deletion levels are high (80%) and protection is low (EPR of 36%), and were it not for ad-hoc policies (such as fluctuations in ADBP credit levels and the Awami Tractor Scheme) the industry could well have been an export industry by now.

It is thus imperative that detailed deletion plans and achievements become transparent and be coordinated as part of a broad engineering development plan.

5. LOCAL MANUFACTURING CAPABILITY

A first step towards understanding the technological capabilities available in the country is to identify the components being manufactured in the country. A summary is provided in the tables and figure

For instance Brazil was able to achieve over 90 percent deletion and lay the base for a strong engineering industry within five years in the late fifties. See H. Shapiro, Engines of Growth: The State and Transnational Auto Companies in Brazil, Cambridge: Cambridge University Press, 1994.

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below. Details for each component are available in various published documents. Further studies are necessary to examine the competitiveness of local manufacturing (compared to international levels) in terms of cost structures, skill and investment requirements.

Figure 3: Manufacturing Cost Breakdown for 800 cc car

- ,

Source: Industry Specific Deletion Program (ISDP) 1996-97, Engineering Development Board

Tables 4 and 5 present deletion levels for 800 cc and 1500 cc cars by major component category. An explanation of the columns is as follows:

Maximum: The maximum which can be deleted in this category. This is actually the same as the percentage of manufacturing cost for the component. Thus for an 800 cc car 22 percent of the cost is allocated to the engine6.

Column A: The percentage of parts which have been successfully developed by at least one OEM.

The Engineering Development Board should undertake a study of cost structures in different countries. Due to different factor costs (labour versus capital) the cost structures would be quite different.

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Table 4: Deletion levels (800 cc car) Component Engine Power train & Chassis Body Interior Trim Electrical Vehicle Assembly Total Maximum 22
18

A
6.30 7.82 15.66 14.02 6.46 10.00 60.26

6.67 4.96 4.57 2.63 2.04

0

9.03 5.22 1.77 1.35 1.50

0

22 18
10

10.00 100

20.87

18.87

Source: Industry Specific Deletion Program (ISDP) 1996-97, Engineering Development Board

Table 5: Deletion levels (1500 cc car) Component Engine Power train & Chassis Body Interior Trim Electrical Vehicle Assembly Total Maximum
20.0 17.5 29.0
11.5

B 6.84 5.93 7.34 4.82 3.05 0.65 28.63

C 10.70 8.64 19.46 1.12 1.40

0

2.46 2.93 2.20 5.56 5.55 11.35 30.05

10.0 12.0 100

41.32

Source: Industry Specific Deletion Program (ISDP) 1996-97, Engineering Development Board