By Brad Haynes
SAO PAULO (Reuters) - Growth in Brazil's car market has screeched to a halt, but it is way too late for automakers to hit the brakes.
While domestic sales retreat and exports plunge, Brazilian factories are adding over a million vehicles of new capacity in just a few years, battering profitability in the world's fourth biggest auto market.
By 2017, global carmakers will be set up to build 6 million vehicles a year in Brazil even as local sales may struggle to pass 4 million, analysts say. They blame heavy-handed industrial policy and an excess of emerging-market euphoria.
"Everyone jumped on the bandwagon," said IHS Automotive analyst Guido Vildozo, citing oversized ambitions in Brazil after sales averaged 10 percent growth in the past decade. Carmakers are now investing about $5 billion a year in local assembly lines just as the market starts to shrink.
Profits have been the first casualty of the oncoming squeeze and labor relations could be the next, with the specter of layoffs looming in a presidential election year. A scramble for export markets also highlights the competitive gulf separating the industries in Brazil and regional rival Mexico.
"It's going to be a painful process, especially negotiating with the unions, but we're not expecting anyone to close shop," Vildozo said.
Long the darlings of Brazilian industrial policy, carmakers are in a bind precisely because of the protections they enjoy.
President Dilma Rousseff and predecessors have kept auto sales chugging along with tax breaks, cheap credit and import barriers, which encouraged a host of uncompetitive auto plants.
The result is a crowded and inefficient industry shackled to its domestic market, with few export options except a crisis-prone neighbor, Argentina.
Sales and output in Brazil have doubled since 2005 to around 3.8 million vehicles last year, but exports fell 40 percent to about half a million cars, trucks and buses.
When the going was good, automakers enjoyed fat profit margins on outdated platforms like a 56-year-old VW van that only went out of production last year. But the party is over for the biggest brands in Brazil, after years of depending on cash from local units to offset meager global growth.
Fiat SpA , Volkswagen AG , General Motors Co and Ford Motor Co saw profits plunge at their Brazilian units last quarter due to slipping market share, rising costs and a weaker currency.
Concerns spread through the industry in late 2013 over growing lines of new cars backed up at factory patios. Analysts reported that dealers were offering discounts of as much as 35 percent to clear expiring models.
Brazil's market may be in the middle of a three-year slump, according to Stephan Keese of auto consultancy Roland Berger in Brazil. He warns that the glut of new factories in a weak economy could lead to more than 30 percent excess capacity in the next few years, about double the industry's usual slack.
Rosy forecasts from the boom years are only partly to blame, he added, as Rousseff's policies forced many brands to build local plants in order to avoid steep taxes on imported content.
"The overcapacity was foreseeable because it was not supported by the market. It was largely about government intervention," said Keese.
WORLD CUP DISRUPTION
Rousseff has coaxed along the industry with both carrot and stick, but the tax breaks she unveiled in 2012 to prop up demand have provided diminishing returns. Last year sales fell 1 percent despite the costly stimulus, the first drop in a decade.
The tapering of those incentives, along with tighter credit, shaky consumer confidence and the disruptions of hosting the soccer World Cup starting in June, could cut sales in Brazil as much as 3.5 percent this year, according to Keese.
Another government rescue is unlikely, and not just because of a tight budget target as Rousseff seeks re-election.
Expanding access to new cars has long been an easy crowd pleaser for Brazil's ascendant middle class and the industrial unions at the heart of the ruling Workers' Party. However, that political calculus is starting to change.
Outrage over a lack of decent public transportation set off a wave of protests last year, drawing more than a million Brazilians into the streets. Awful traffic in major cities and a lack of public investments led many to question why the government was using tax breaks to put more cars on the road.
The auto industry argues that it provides more than 150,000 jobs and over a fifth of Brazil's industrial output. Carmakers have announced about $35 billion of capital spending from 2012 to 2018, helping to lift the country's dismal investment rate.
Yet even automaker association Anfavea concedes that sales in Brazil will not absorb more than three quarters of the country's capacity by 2017, when local plants should be able to produce over 6 million vehicles per year.
"This is a good problem to have," Luiz Moan, a senior GM executive currently in charge of Anfavea, told journalists this week. "We know we need to gain competitiveness so we can export at least a million units in 2017."
That process has started with policies requiring carmakers to update their Brazilian assembly lines along global standards rather than recycling outdated models. Anfavea is asking for more government measures to help it boost exports, including new tax benefits, trade deals and preferential financing.
HEAD TO HEAD
To hit Anfavea's goal would mean doubling exports in four years with a push into regional markets - pitting the industry against its far more competitive counterpart in Mexico.
Mexican factories have lower labor costs, easy access to U.S. suppliers and 43 free trade agreements supporting their export-focused industry, according to Vildozo of IHS.
Brazil has just six bilateral agreements on auto trade, including four immediate neighbors and South Africa. Bilateral trade with Mexico has suffered since 2012, when Brazil imposed two-way quotas to stem a flood of Mexican imports.
The European Union, another potential trade partner that Moan cited, is pressing a case against Brazil at the World Trade Organization over its taxation of imported cars.
"From an export standpoint, all of Brazil's eggs were in one basket: Argentina," said Vildozo. "And that basket has cracked."
Plunging foreign reserves in Buenos Aires have led to severe trade restrictions, and Brazilian auto exports started the year with a 24 percent drop. Argentina has recently received as many as nine in 10 Brazilian car exports.
The new restrictions hit Argentina-focused automakers such as PSA Peugeot Citroen especially hard, according to Camile Janz, who covers Brazil for LMC Automotive.
PSA is one of a few companies that have backed off expansion plans in Brazil, although many committed years ago to plants that are only now coming online.
Some companies, such as Hyundai Motor Co <005380.KS>, have even managed to win a bigger share of Brazil's crowded market with new models from recently installed factories.
But the shrinking market makes that a zero-sum game. As the number of players rises the success stories are getting scarcer, according to Keese, the automotive consultant at Roland Berger.
"There are very few automakers that are actually profitable in Brazil at the moment," he said. "The old business models really don't work anymore."
(Editing by Todd Benson and Ross Colvin)