Friendship On Wheels

Volkswagen Group Rus

The opening of an engine manufacturing plant in Kaluga

German carmakers are keeping their production in Russia and working to implement new projects despite the crisis in the automotive market and political tensions.

"He's a fine man. A truly reliable person and entrepreneur. He has made good on all our agreements," Russian President Vladimir Putin said about Martin Winterkorn — at the time still chairman of the board of Volkswagen — after the opening of the German auto group's newest machine factory in the Kaluga region in September. The project cost the company 250 million euros, and its estimated capacity is 150,000 engines per year. At the moment, the engines are assembled at the plant from imported components, but before the end of 2015, the factory will start purchasing the necessary items from local suppliers.

The engine factory opened in the midst of a crisis in the Russian automotive market. At the end of August, sales of new passenger cars and light commercial vehicles (LCVs) had tumbled by 33.5 percent, year on year, according to estimates from the Association of European Businesses. This was against the backdrop of sanctions imposed on Russia by Western countries and an intensifying devaluation of the Russian ruble. In 2013, the market decreased by 5 percent, and it dropped by 10.3 percent in 2014.

The collapse of the market has forced American carmaker General Motors to suspend production in Russia, but Volkswagen has proved more resilient — mainly due to a greater localization in Russia for components of its mass-produced cars.

Under Its Own Steam

In Russia, Volkswagen Group can import car parts at a reduced rate due to its "industrial assembly mode" agreement with the Russian government. Similar documents have been signed with other major automakers. In return for the preferential treatment, the company must fulfill a number of conditions.

First, it is necessary for Volkswagen to create the capacity to fully produce no fewer than 50,000 cars in Russia. A full production cycle includes welding, painting and final assembly. Volkswagen can use the facilities of partner producers to build the cars. The company has already achieved this first condition of the agreement — its manufacturing plant in the Kaluga region can produce 225,000 cars a year. The company has also agreed to produce a range of models at the Nizhny Novgorod facilities of GAZ Group, Russia's largest producer of LCVs.

Another condition stipulated in the agreement on industrial assembly is that a third of the components for cars, engines and transmissions are to be produced in Russia. Volkswagen Group did not agree on the procurement or contract assembly of engines in Russia, but still built the factory.

The third basic condition of the agreement on industrial assembly is that the firm must increase localization of vehicle production in the country to 60 percent by 2020. The Volkswagen Group's stats for localization are already at 45 percent, and by the end of the year, it will reach 50 percent.

However, Volkswagen Group, along with other foreign carmakers that have built factories in Russia, insisted as part of the agreement that a coefficient be added to the formula for calculating the level of localization in order to offset currency fluctuations. With the present approach, the stronger the euro or the dollar is vis-a-vis the ruble, the lower the percentage of necessary localization. After the ruble was sharply devalued late last year, foreign companies began to worry that they would never be able to meet the agreed-on localization levels. Russian authorities have not given any indication one way or the other, but officials are still discussing the possibility of introducing a corrective factor.

Partners for Daimler

Other major German automakers are also betting on the long-term future of the Russian market.

Daimler is also taking advantage of a preferential industrial assembly regime in Russia. The Daimler deal is part of a multilateral agreement with the government that involves the Renault-Nissan conglomerate and Russian firms AvtoVAZ and KAMAZ.

In late 2008, Daimler acquired a capital share in KAMAZ, buying 10 percent of the company for $250 million. Daimler later raised its stake to 15 percent by purchasing an additional 4 percent from the European Bank for Reconstruction and Development in 2014.

Until this year, Daimler and KamAZ had two joint-ventures to produce trucks. One produced the heavy-duty Mercedes-Benz, and the other the mid-sized Fuso. But in the context of the declining market, the joint-ventures were reformed into a single company called "Mercedes-Benz Trucks Vostok."

Daimler also wants to start production of passenger vehicles in Russia. The company sees that there is strong demand for premium cars even despite the overall market decline. Additionally, local production will give Daimler the opportunity to participate in Russian state industry support programs, such as the automotive fleet renewal program and preferential car leasing, as well as the chance to be involved in public procurement.

Market sources have said that Russian production of Mercedes-Benz passenger cars may be organized in conjunction with KAMAZ, although it is unlikely that production will be located in Tatarstan, where Mercedes-Benz Trucks Vostok operates, since in the premium passenger car segment, it is important to be close to sales markets.

Daimler has been searching for a suitable site for the production of Mercedes-Benz passenger cars for several years now. Among the main options the company is considering are St. Petersburg, the Leningrad region, and the Moscow region. Negotiations have taken place on the possibility of producing cars on a site belonging to Russian vehicle manufacturer ZiL, but the parties have yet to agree on terms.

BMW Finds Success Without Agreement

Against the background of the Volkswagen and Daimler projects in Russia, BMW's efforts look modest. The company feels quite confident in its Russian operations, however.

BMW cars are produced at the facilities of Kaliningrad's Avtotor, which specializes in contract manufacturing. BMW has no agreement on industrial assembly, but the company does have beneficial terms for the import of car assembly kits. This regime takes advantage of a special economic zone operating in the Kaliningrad region. These beneficial terms will end in 2016, and the government is considering an option that would maintain a preferential regime via the WTO.

A replacement solution could take the form of an agreement on industrial assembly, which Avtotor Group already has. Such an agreement would be necessary to build full-cycle manufacturing plants in Kaliningrad. One of Avtotor's partners has been holding meetings with BMW, but the turbulence in the Russian market has the German carmaker in no hurry to make a decision.

Local Market Too Small

A falling market and incomplete utilization of capacity has forced automakers that have built factories in Russia to investigate export options, and not just for cars. For example, in addition to vehicles, Volkswagen Group is hoping to sell its engine parts produced in Russia abroad. This plan will support the new engine plant built in Kaluga and will capitalize on the weak ruble.

Here too, though, state support is in demand.

"If Russia wants to be competitive, then it cannot be limited to only the domestic market — it is too small," said Volkswagen Group Rus's general director Marcus Osegowitsch at the Frankfurt Motor Show, according to news agency Interfax. "Our cars are competitive in the world in terms of technology and quality. Price remains a weak factor. The logistics component is very expensive."

The company hopes that officials will offset some of the costs associated with the logistics of supplying products abroad, as well as the payment of customs duties on foreign markets. The Russian government is currently discussing this with automakers. A plan to support automotive industry exports is now being prepared by officials.

Russia - Germany 2015
Russia - Germany 2015
Despite the difficult political climate and economic downturn, German companies remain committed to Russia. Read about the challenges facing them, as well as success stories in this supplement.
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