Thailand is known as the "Detroit of the East" for a reason. The country churns out 2.5 million vehicles every year for major global automakers. Due to geographical proximity, free trade agreements, and low-cost structure, Japanese automakers have built big manufacturing hubs in the country. But political protests coupled with diminishing demand in the auto industry are crippling future growth.

The dual impact is not only leading to local sales declines, but there is also a possibility of production cut that can affect exports. While most players are finding the situation worrisome, it's doubly difficult for Toyota Motors (NYSE:TM). The company has won the global sales crown for two years in a row, and has to maintain its edge if it is to retain the top spot over the coming years.

Toyota Picture
Toyota's Ban Pho Plant in Thailand. Image: Toyota

Toyota was banking on Thailand
Every 20th car that Toyota sells is bought in Thailand, which makes it an important sales destination for the Japanese auto giant. Its importance also lies in the fact that Thai-made vehicles comprise a big portion of exports to countries like Australia. Roughly 20% of the cars sold in Australia are made in Thailand. Toyota, the top car seller Down Under, has been taking advantage of the free trade agreement between the two nations and sourcing more and more units from Thailand. The latest to drive out of Thailand will be Toyota's Corolla sedans, which were earlier being made in Japan.

In 2013, Toyota made around 850,000 cars in Thailand -- it sold 445,000 to local residents and exported about 430,000  vehicles. Over the next three to four years, it is planning to boost its production capacity by another 200,000 units. This would mean that the country alone would account for 10% of the company's total installed capacity, and the growing export sales would help Toyota achieve its ambitious sales targets. The company is gunning for an unprecedented 10 million vehicles sold in 2014.

The demand downturn
The Thai auto industry is facing a severe slump in demand, and Toyota's Thailand chief Kyoichi Tanada has predicted a 14% industry-wide sales drop in 2014.

The immediate reason for the fall in demand is possibly the withdrawal of the rebate to first-time car buyers -- this scheme had helped the auto industry record 80% sales growth when it was introduced in 2012.

However, there is also the issue of the slowing economy that could have far-reaching consequences. The Thai economy has suffered a severe blow from the anti-government protests. The persistent unrest could bring down the economic growth rate to a paltry 3% -- a sharp decline from the 6.4% recorded in 2012. This will invariably hit business growth prospects and dampen consumer spending.

Toyota's sales in Thailand could decline 10% in fiscal 2014, which ends in March. This would be its second annual slump in a row. Through the current calendar year, the company expects to sell 400,000 cars locally and export 445,000 units.

Toyota's Japanese rivals Honda (NYSE:HMC) and Nissan (NASDAQOTH:NSANY) are facing similar challenges in Thailand and both companies witnessed a decline in sales in 2013. Honda expects its sales to fall 23% in fiscal 2014 (ends in March). This has prompted the company to lower its global sales forecast for the fiscal year by 1% to 4.385 million units. Nissan's sales fell 20.7% in its 2013 fiscal that ended in December, but unlike Toyota, it's more optimistic about the Thai economy in 2014. It expects conditions to stabilize and has set a target of selling more than 100,000 units in 2014.

Time to think about Plan B
Toyota may reassess its plans in Thailand should the political unrest continue to pull the economy down. The company may abandon its current plan to invest 20 billion baht (approximately $609 million) to boost its capacity by 200,000 vehicles over the next three to four years. If the situation worsens, the Japanese carmaker could even cut production to maintain a balance between supply and demand. This strategy is a part of Toyota's production system and is largely known as the "just in time" approach.

But Toyota's Japanese rivals have not yet voiced anything about abandoning their investment plans in Thailand. Nissan will be investing 11 billion baht ($335 million) to build its second manufacturing plant, while Honda's next facility will involve investments of 17.2 billion baht (roughly $560 million).

So we need to wait and watch the turn of events. If Toyota's strategy does not work out as it hoped in Thailand, perhaps it could fall back on Indonesia. The company already has a production base in Indonesia, which has a low-cost structure as well.

Parting thoughts
Thailand offers great opportunities on account of the free trade agreement, cheap labor, and low manufacturing costs. Toyota was quick to spot the advantages and has reaped rich benefits. Falling demand and political disruptions dampen the company's future prospects in the country. Maybe the time has come for Toyota to explore other markets, like Indonesia?

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