Saudi car gets green light, but is it a goer?

In creating a viable car industry, the kingdom's key test lies in avoiding a basket-case scenario maintained by government protection, subsidies and loans.

Saudi Arabia's King Abdullah looks over a prototype of the Ghazal. The SUV could help the country diversify its economy.

Saudi Arabia's first step towards a domestic car industry, a prototype called the Ghazal, has received a green light for production. According to press reports, an investment of between US$400 million (Dh1.46 billion) and $500m will be needed if it is to reach its target of making 20,000 vehicles a year.

The venture began as a project at King Saud University and is vaunted as an exciting new element of Saudi industrial diversification. One of the key motivations behind the project is to showcase the development of domestic human capital - the skills, knowledge and technical capability that will see the economy move away from dependence on foreign workers and hydrocarbons. With a young and rapidly growing national population, the need for jobs and skills creation is taken seriously by the kingdom's economic strategists. The social sustainability of the nation will rely on creating an economy that provides jobs for skilled Saudi workers who are paid a decent wage.

These themes of diversification and human capital development have been a priority in Saudi Arabia for various iterations of national planning - plans that have seen significant investment in educational facilities and industrial projects, aimed at fostering technological know-how and commercially viable production activity. The Ghazal is a product of this process but while the project is an achievement in design the commercial viability of taking the vehicle to production should be scrutinised carefully to see whether it will be $400m to $500m well spent.

Creating a domestic car sector from scratch is not only capital intensive but can take years to bring any financial return. Malaysia's car sector began production in 1985 when Proton opened its first line, initially using components manufactured by Mitsubishi and, over the years, increasingly using locally designed and manufactured components. In 2001 Proton launched the first model designed entirely in-house. Since then it has produced various Malaysian-designed and built vehicles for the domestic market and for export.

Proton's development has come at a cost though, and the company is a case study in protectionism. Fostering internal demand for the company's products was achieved by taxing the competition heavily, thus making the domestic models comparatively cheaper since Proton has been exempted from, or rebated, tariffs on imported components. This worked extremely well and within three years of the first model hitting the road Proton had captured 73 per cent of the passenger car market. To compete, however, foreign manufacturers have sought to work within the tariff framework that taxes completely built-up (CBU) vehicles more than completely knocked down (CKD) vehicles, that is those imported as only parts. As a result they reluctantly invested in assembly facilities in Malaysia, some of which had been planned for neighbouring Thailand, to avoid tariffs and bring prices of imported vehicles closer to domestic models.

Closer to Saudi Arabia, Iran is home to the largest car firm in the MENA region, Iran Khodro, which began importing CKD vehicles in the 1960s. The first model to be imported was the Peykan, a modified version of the British-designed Hillman Hunter, which was then manufactured under licence and took the mantle of being the Iranian "national car". Production of the Peykan continued until 2005, with various minor modifications and the vehicle is still the most ubiquitous on Iran's roads.

Iran Khodro was also active in bringing other models to the Iranian market during this period. Since the 1979 revolution, companies including Peugeot, Citroen and Mercedes have all entered into agreements whereby their models are produced under licence. In 1996 however, the company began a project to launch a domestically designed national car to replace the Peykan; this reached the market in 2000 in the form of the Samand. Although still based on the Peugeot 405 platform, the vehicle is made of parts sourced entirely from Iranian manufacturers and is powered by an Iranian-designed hybrid engine. As well as domestic production the Samand is also produced under licence in Belarus, Venezuela and Syria.

Further research and development projects are still under way and the company has invested heavily in production facilities, but some signs of overreach emerged last year when the company faced a liquidity crisis. The Iran central bank announced a rescue package worth $1bn, while a statement from the company's chief executive acknowledged that past investments were not profitable. For Saudi developers, the key to creating a viable domestic car sector lies in the avoidance of an economic basket-case scenario, maintained by government protection, subsidies and loans. In the cases Iran and Malaysia, fostering car firms has required harsh tariffs to maintain the competitiveness of what is perceived as an inferior product.

Where establishing car production has been commercially viable it has involved manufacture and assembly of foreign-designed vehicles under licence. Solely manufacturing vehicles under licence would, however, undermine the government's motivation to develop and showcase Saudi engineering skills. Potential investors will have to consider what competitive advantages a new car plant might enjoy in Saudi Arabia. The principal factors of car production, namely labour and steel, are not advantageously abundant or cheap in Saudi Arabia; what cheap labour there is tends to be among non-national members of the workforce.

Creating a heavily-subsidised sector that relies on foreign labour would probably be regarded as the antithesis of the vision behind the Ghazal. The Ghazal project should be seen in context though. Although details of the design, and how much it relies on pre-existing components, are scant it would appear that the chassis and much of the rest, including the drivetrain, are all from existing models, in particular the Mercedes G-Class. So far the project has not required the vast capital outlay of designing a new model from scratch and the focus has been on providing a heavily customised variant of a vehicle already popular in the region.

Furthermore, the stated initial production target would represent less than 3 per cent of the kingdom's annual vehicle sales by the time it comes online, a figure that would probably be readily absorbed in a market that has been growing rapidly in recent years. With government support from the highest levels, the Ghazal could be on the road in a matter of years. The initial production volume will hopefully not require import tariffs for protection, but if this is to become the cornerstone of a Saudi car-making sector with larger scale projects involving the design and manufacture of a truly Saudi car then the government should be prepared to spend for many years to come. Before doing so it should consider if that will money could be spent on more viable attempts at diversification and skills development that look less like import substitution.

Henry Collis is a freelance economic analyst based in Dubai