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Chrysler employees assemble cars at the plant in Brampton, Ont. The facility makes full-sized sedans, which are losing market share in North America to fuel-efficient compact cars.

Just as the auto industry recovery kicks into a higher gear in Ontario, billions of dollars in new investment in southern North America and a shift to smaller vehicles are threatening the long-term health of the province's key economic engine.

Auto makers produced more vehicles in Ontario than they did in Michigan again last year, but these trends are alarming in what auto makers say is now the highest-cost country in the world to make cars and trucks.

Vehicle companies raised output by 3 per cent in Canada last year – despite the permanent shutdown of a Ford Motor Co. of Canada Ltd. plant last fall and lengthy disruptions at Honda of Canada Mfg. and Toyota Motor Manufacturing Canada Inc. because of the Japanese earthquake and tsunami.

While production here bounces back slowly from the trough it hit in the depths of the recession, investment in Mexico is mushrooming and is poised to grow even more as tightening fuel economy and emissions regulations push buyers into smaller vehicles.

This poses a mortal danger to Ontario and its already struggling manufacturing sector because more than half the vehicles assembled in the province are large and sit in the bull's eye of new fuel economy and emissions rules.

"Almost all greenfield [investment]is going to be small products because of the environmental regulations and we can't compete on small products," said industry analyst Dennis DesRosiers, president of DesRosiers Automotive Consultants Inc. of Richmond Hill, Ont.

The key advantage Mexico enjoys as North Americans gradually downsize their vehicles is cost – wages are about one-sixth of the $32 an hour the Detroit Three pay their Canadian workers – which is critical in the assembly of small cars because profit margins are razor thin. Three Japan-based auto makers have plants under construction in Mexico that will come on stream by 2014 to make subcompacts, also known as B-segment cars.

It's almost impossible to build a case to make vehicles of that size profitably in Canada and the U.S. Midwest, Mr. DesRosiers said, although General Motors Co. has begun making the subcompact Chevrolet Sonic at a Michigan plant. That's in part because the United Auto Workers agreed to wages for new employees that are about half the level of what existing employees receive.

While Ontario looks enviously at Mexico, the U.S. South is also booming as Europe- and Japan-based auto makers boost production at their plants in Alabama, South Carolina and elsewhere as they slash exports to North America from their home countries to reduce the volatile impact of currency swings.

If the federal and Ontario governments want to retain this country's existing auto jobs and production, they will likely need to play harder in the incentive game in which southern states and Mexico dole out hundreds of millions dollars to land such investments, Mr. DesRosiers said.

The North (plus Canada) to South (plus Mexico) shift has been going on for much of the past decade, but it's picking up speed.

Mexico's share of North American vehicle production stood at 11 per cent in 2000. By last year it had grown to 20 per cent.

In January alone, three companies announced plans for new assembly plants or expansions in warmer climes, notably a factory that Nissan Motor Co. Ltd. will build in Mexico to make 175,000 subcompact vehicles a year. During the next three years, auto makers in Mexico and the U.S. South are scheduled to increase output by a staggering 700,000 vehicles, or 13 per cent above 2011 levels.

Toyota Motor Corp. said Monday that it has added a second shift at its plant near Tupelo, Miss., which is scheduled to crank out its full capacity of 150,000 compact Corolla models this year, compared with just 2,000 last year as it got up and running.

Not only did the new investments pass Ontario by, but government officials are wrestling with the question of how to hang on to what is already here. A GM factory in Oshawa, Ont., is scheduled to close and Ford is seeking government financial assistance to retool the only vehicle plant it has left in Canada.

Those factories make vehicles in the segments of the market that have stayed static or shrank in recent years as gas prices have soared. So does the Chrysler Group LLC plant in Brampton, Ont., that makes full-sized sedans or E-segment cars.

The subcompact and compact segments are expected to grow even more and the full-sized sedan market should shrink as more fuel economy regulations in both the United States and Canada come into force later this decade.

Those two trends are already evident.

Subcompact sales more than doubled between 2000 and 2011 to 5.4 per cent of the North American market. But sales of vehicles one size larger, compacts, surged to 30.1 per cent from 19.5 per cent, data compiled by Mr. DesRosiers show.

Sales of full-sized cars plunged to 25.2 per cent of overall North American deliveries from 38.7 per cent in 2000. That doesn't mean drivers have traded in their Chrysler 300s for Toyota Corollas.

More likely they have traded down to a mid-sized or D-segment car while millions of mid-sized drivers scaled down to a compact during that period.

But the drop in sales of E-segment vehicles is a trend that affects Ontario because they represented 41 per cent of the province's production of 2.1 million vehicles over all last year.

There was more evidence last month that the U.S. drivers are downsizing their vehicles.

"Small-car sales increased as a per cent of total sales from just under 19 per cent in December to almost 23 per cent of the market in January," Erich Merkle, U.S. sales analyst for Ford Motor Co., said on a conference call on the auto maker's January sales figures.

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