Monday, 30 January 2012

Macro Level Trends – European Economy – Devising Pragmatic Paths for Auto Sector Structural Reform in a New Dual Speed (Hybridized) Europe.

Last week saw global leaders from industry, finance and politics meet at the annual Davos event. High on the agenda of course, the sluggishness of pan-global economic growth, exempting the good news from China and the 'great expectations' of North America.

Given the financial and structural economic woes of much of Europe – with the national credit down-grading of France heightening fears about 'core contagion' and correlated delay in the EU's eventual rebound – the 'big picture' raison d'etre of the event has been EU solution seeking. Thus it may be argued that the event's focus continues to be about the here and now, but such supposed short-termism - which is actually in the long-term interest – has been the recurrent theme ever since 2008.

The global grand schemes of yesteryear have seemingly become marginalised, and perhaps none more so than the high-ideal ecological ambitions made almost sacrosanct by the 1997 Kyoto Protocol, even if not ratified by the major players and so formalised. Nonetheless, intent for change was there, and the eco-challenge still sits in the political background, even if superceded by fiscal and now nationalist concerns within the EU.

Recent years and associated hard times of late have understandably led to reticence amongst policy-makers and capital markets participants to optimistically push for drastic eco-orientated transformation. High costs, wavering confidence and often increasingly delayed or possibly ethereal ROI timelines (at domestic and state levels) means that the whole arena, ideology and discipline of 'Environmental Economics' has come under the 'pressure of pragmatism' as never expected in the 30 years prior to 2008; given the 'golden era' characteristics of that period.

[NB However, there have been exceptions, as discussed in a previous post, the Mayor of London introduced the LEZ (Low Emissions Zone) as of 01.01.2012 effectively banning older, heavy diesel engined vehicles from London streets].

Nonetheless, whilst scheduled programmes of change have been seen, the participants at Davos well recognise that it is in the midst of such daily and weekly turmoil that the art of grand schema is most required, and that is presently directly at economic need, over and above ecological.

However, that is not to say the two are mutually exclusive, indeed crafting the former need properly can actually propogate the later, by creating a more fertile soil for future growth.

It is this outlook of optimism, for turning challenges into opportunities, that the title of this year's Davos event chimes: 'The Great Transformation: Shaping New Models.'

The very fact that this title was chosen - each year's title generated by reading in between the lines of general consensus - points to the evident understanding of a much altered 'power-broking' basis in the global economy between East and West, aswell as recognition that the ecological challenge whilst presently in the background is forever with us as living standards across the globe rise.

Within this broad context, the emergence of the EU economic now sets 'conditional demands' for adapted and wholly new socio-economic 'progress paths' to be nationally, regionally and internationally constructed.

The fact that China's representation at Davos was lesser than expected indicates that China is subtly demonstrating its potential power to relieve EU woes, whilst also allowing it to remotely view a less guarded US – Euro relationship as would have otherwise been the case.

Contrasting such real-politik was CNN News' typical popularist manner of questioning Davos participants as to whether leaders were “ahead or behind the curve” regards the EU crisis; using the austerity of a basic flip-chart and re-orientated WEC logo as the base for its version of 'pin the tail on the donkey'. Mixed opinion returned. The IMF's MD & Chair Christine Lagard set out two positions – slightly ahead and slightly behind the apex of the curve – to illustrate both intention and reality. A similar dual depiction with far greater distance was given by Prof. Nuriel Rubini.

This the difference of perception (or rather of outward presentation) of these two individuals perhaps unsurprising given their respective backgrounds. Yet it outwardly suggests that the 'EU problem' is a long term one, and may only be fixed by ongoing phases of structural reform which thus attract broad-base liquidity injections for many years to come. That time scale also driven by inter-regional political complexity and the subtle tussle between cash injections provided by intentional ongoing Euro devaluation (QE), provision by the international capital markets and any 'saviour' offerings by China and other SWF's latterly returning to the table who would presumably only truly leverage their US$ FX reserves (from export income and petro-dollars) once the Euro has reached parity with the US$ - a small trickle flow of money until then.

Yet, the very notion of 'the curve' euphemistically used by CNN is a misnomer. The reality being that a multi-speed Europe must best manage divergent slopes of much muted prosperity, economic flat-lining and very real medium term watershed decline.

At worst this inescapable reality impels the eventual collapse of the Euro, as many doom-mongers predict. Yet a return to individual national currencies would be relatively chaotic, and would logically lead to each 'un-coupled' nation seeking ever greater competitive advantage over its preceding neighbour through ever greater devaluation efforts; notably via nation based QE and literal (old fashioned) currency printing to re-inject liquidity and consumer spending, as opposed to routing less visible but arguably more powerful liquidity through the investment disciplines of the banking industry.

In contrast, a best outcome scenario would be that the divergent fortunes of EU members allows Germany to take a greater lead, and with broad plan agreement by 'fellow-step' neighbours, providing for the slow remoulding of industrial and commercial Europe. This has been criticised as creating little more than an EU of 'Little Germanys', but would undeniably provide for far sounder national economic platforms, and indeed socially may well instil the German traits of caution, learning and self responsibility.

Importantly, any solution that sees the EU retain its shape would require a coordinated effort amongst members to allow the Eurozone to subtly massage the Euro's global valuation relative to future global conditions. Done so by in a pro-cyclical manner, able to leverage the fundamental economic differences between EU countries. Thus using the now emerged growth disparity gap to locate specific activities vis a vis the global competition in the most promising locations throughout Europe. This then in a similar vein to the FDI investments seen in 'New Entry' EU countries over the last decade or so. So in effect creating captive deflationary and inflationary zones suited to specific goods and service sectors.

If indeed a long-term hybrid '2-speed Europe' can be sustained to the benefit of investors seeking ROI from specifically aligned commercial and industrial sectors, the peoples of retained member state countries would gain from such Ricardo-esque re-orientation of geographically based core competencies; whilst in the interim benefiting from the support of German commercial assistance, the funnelling of EU and ECB monies via the ESM and ESFS aswell as the IMF.

Critically this route of 'twin Europe' plays to the best of both worlds, allowing member states the freedom of self-directed re-conceptualisation - if fundamentally watertight as a building bloc of a renewed Europe - aswell as the broad political support network to achieve realistic change. All at a lower cost than 'dropping out' altogether and so becoming reliant upon the demands of what would be seen as voracious free capital markets, which in themselves have a remit to allot investment capital on strict investment terms, even given the rhetoric of socio-consciousness.

[NB This creation of a dual-aspect 'Hybridized Europe' would then recreate a similar economic base to that of Europe in the post-WW1 & post-WW2 periods. Yet this time the spectre of Communism replaced by far a greater sensitivity by the 'hand in hand' power-brokers of Capitalism to social needs; a very real necessity given the sea-change of populist attitudes Thus perhaps closer to a re-run of Victorian Britain in which leading-light industrialists literally physically built a better world for employees, and privately directed philanthropic funds acted in the broad human interest, both initiatives arguably more effective in creating the 'public good' than state-run organisations which today across Europe have arguably little financial accountability to the populace and little in the manner of measurable 'social output' results. Such 'Conscientious Captalism' was a precursor to later state-run education, health etc programmes, and may today become an evolved successor on a far greater scale].

Such an economic hybridization of Europe might very well require differentiated dual pricing structures of basic goods and services to the public consumer between the EU's struggling periphery and the less impoverished core. This to avoid the type of real-world (inflationary) pricing pain experienced by the then periphery countries when the Euro came into being in 1999, and affect only consumer staples such as food, utilities and typically non-taxed critical goods such as children's clothing etc.

This would in turn provide for new employment roles within the state to ensure that basic prices of foodstuffs, petroleum etc were maintained, so eradicating profiteering and that black market 'arbitrage' between ('cheap') periphery and ('expensive') core was prohibited.

Yes, such a economic development path for the whole EU region need not have historical overtones of great division, as seen previously with Eastern and Western Europe. A freedom of movement for goods and people (though with certain economic strictures) would stay engrained, and there would be no physical barriers or militaristic checkpoints beyond those needed to maintain national security, and the emergence of electronic tagging, IT and the 'connected world' means that law enforcement can be far more subtle. Less intrusive and indeed effective.

Any such details would need very careful assessment, but the primary issue at hand is that the inescapable reality of a long term 2-speed Europe is accepted as the true state of play by all members within the region. Instead of – as seems presently the case – the denial of the new EU economic picture and the associated political infighting which presently post-pones a credible economic solution to the good of all, most notably each nation's peoples.

On the surface a 2-speed Europe looks to be a momentous failure but it must be recognised that the past good fortunes of the periphery countries through the 1990s and 2000s was built upon use of 'credit supercharging' by respective governments to grow state employment, by firms seeking to utilise the then lower labour costs, and by banks lending on a property bubble. Exempting portions of Italian and Spanish industry, little of that apparent growth was tangible industrial productivity of real use to the the nation, EU region or indeed world at large.

To this end, unlike EM growth in Asia, the Mid-East or South America, the EU's periphery lived well inside a more or less self-contained universe. But that universe is now recognised as little more
than a black-whole that is presently still unquantifiable in true value terms by many, including most importantly the investment community.

Thus a very real fundamental change is necessarily required so as to regenerate those economies via truly productive activities that can be both self-consumed and exported elsewhere.

And to this end, the automotive arena across Southern Europe – primarily in Italy & Spain - should take this rare opportunity for fundamental review of its global positioning and recognise the benefits of 'whole-sale' (ie value-chain) reconstruction, so as to step into the future by creating a true “Tier 0.5” production hub that can feed the multitude of European brands.

As has proven throughout history and especially over the last two decades, the present over-matured - and thus often value destructive - sector business model has increasingly relied upon industry consolidation (ie GM Opel-Vauxhall, FIAT Group,VW Group, PSA Group), the sale of intrinsically uncompetitive companies to foreign newcomers (ie Volvo to Geely and now SAAB to possibly either China Youngman, Turkish Brightwell or India's Mahindra) and the increasing deployment of shared platform projects underpinning seperately skinned and badged cars.

Unquestionably the economics of European production by 'empire VMs' has come under question time and time again. The only companies able to escape seemingly the German trio of VW, BMW and Daimler through brand and geographic expansion and capture of premium and luxury markets worldwide. Yet even they look to JVs to lessen new vehicle project and production costs to maintain profit margins. It is well recognised that FIAT-Chrysler's CEO Sergio Marchionne seeks to partner with another European VM so as to grow scale and thus lessen overall input costs for his Italian-American company. And moreover, the world of contract manufacturing grew ever larger, especially in low and medium volume segments such as Porsche's use of Valmet and BMW use of Magna Steyr.

In business, history and convention states a 'circular' paradigm: that profitability leads to expansion and that expansion leads to profitability. Given the web-like character of the auto industry's value chain, and the intent to maintain as powerful grasp on the value-chain as possible, the willingness to divest of prime manufacturing activity – even when highly questionable since only economically viable during boom periods – has been hard to challenge; international VMs seeking to maintain global presence, use profitability from other regions to bolster Europe, always an executive's insistence that “European operations can be turned around” (rhetoric the BoD wants to hear) and as last resort, the ability to sink costs into Europe so as to bolster further the profits of other better performing regional divisions.

This then the convention

Yet, on paper there is another way forward, one which the fragmentation of the EU into a 2-speed economic bloc offers. That of mass scale contract manufacturing of platforms, module sets, sub-structures and whole vehicles to 'service' many of Europe's VMs. Ostensibly moving the Jv manufacturing model forward a logical step to create a true full-scale Tier 0.5 production category and arena; something oft discussed amongst the investment community and auto-executives, but rarely actioned given massive ramifications across business, investment and society

However, changed times call for changed behaviour, and though against conventional wisdom investment-auto-motives believes that Southern Europe may be ripe for such an auto-sector introduction that can induce scale efficiencies which drive profits for both Tier 0.5 opoerator and the VM client base. Indeed such an intrinsic change could well act as the bedrock for new productive growth across the region.

Further to previous posts regards the Norther Europe Eco-Tech Rainbow, and the expansion of Northern Africa's components and assemblies production capabilities, investment-auto-motives envisages 3 horizontal bands of automotive activity across the EU and MENA region. Respectively Northern Europe to offer R&D, Design & New Product Development (and end-point vehicle production by those companies able to exhibit profitability), Southern Europe to offer mass scale contract manufacturing industry (ie Tier 0.5), and North Africa to grow from Tier 2 base into fully fledged Tier 1 production base at world quality levels, thus able to 'feed' Italy, Spain et al.

Under the banner of 'Conscientious Capitalism' those corporations that have both strong operational and strategic fundamentals should be uninhibited to maintain business as usual, yet those that have proven themselves to be either 'stagnant' or indeed 'value destructive' (and have been reliant upon state aid via cash injections or policy-led market manipulation) should pro-actively seek alternative paths that a 2-speed Europe can offer, so that convincing profitability can once again be achieved

The basic theorum of massively extending the use of contract manufacturing from a Souther EU production hub, echoes similar “change sentiment” for the industry proffered in the book “Time for a Model Change” in which the authors argued the reason for 'industry unbundling'

(AD 2004 / G. Maxton & J. Wormald / Cambridge University Press)
(see Post Script)

The time has surely come for the leaders of European investment banks and leaders of automotive operations to highlight the need to devise pragmatic paths for “auto sector hybridisation” between VMs and a new Tier 0.5 hub. The recent inescapable and long-horizon events within the EU creating a 2-speed region mean that such an opportunity can be seized.

In short the EU's own 'economic hybridization' promotes the basis of 'business model hybridization' and so 'industrial hybridization'; one in which the fundamentally strong VMs march onward and the weaker participants become part of 'new model shift' companies.

Time then for the true 0.5 Tier corporations to come to the fore, either from wholly newly developed synergistic portfolio companies held by private equity, or from the collective margins of VM based contract manufacture, or from expansion of present Tier 0.5 operators, or the onward coalescing of the Tier 1 supply companies morphing into that arena.

Needless to say that such change toward a hybridized region and aligned hybridized industry would almost expectantly lead to the development and popularisation of eco-sensitive hybrid vehicles.

Post Script -

'The primary message of “Time for a Model Change' is - the need to re-create the conventional auto sector, with a central strand that sees vehicles being developed by a sector that operates on a horizontal level relative to vehicle segment type rather than the historic, conventional model by which volume manufacturers seek to build vertical (ie pyramidal) empires. These typically brand based - in an understandable desire to achieve both scale (at the mainstream level) to ensure low-price platform efficiencies, and the desire for premium and luxury production to gain stratified higher margins on increasingly exclusive reduced output.