Profits blinding carmakers in China?

Parka SG

AUG 28, 2003
Profits blinding carmakers in China?

By JAMES MACKINTOSH
RICHARD MCGREGOR
FINANCIAL TIMES

AMONG the many indicators of China's exploding demand for cars, few match the scramble in Shanghai to buy a licence plate. Only a few thousand of the plates - needed even before a car can be bought - are made available each month at a government auction, part of an attempt to limit increasing traffic congestion.

Last month, demand drove the price in Shanghai to a record 38,000 yuan (S$8,000): about half the cost of the cheapest cars in the market and 50 per cent higher than a year ago.

The rising price has spawned a thriving business in nearby quota-free cities where traders buy cheaper licences to sell to eager Shanghainese. 'We can get you a licence for 3,000 yuan, including transportation and cost of a temporary residence certificate - it's so much cheaper than Shanghai,' says Ms Yang Chunyan, a saleswoman at Heping Auto Sales, near Shanghai.

With these and other measures of booming demand, it is little wonder that the boardrooms of global car manufacturers are buzzing with talk about China, a rare bright spot in a world car market sunk in depression. Passenger car sales rose 82 per cent in the past six months year-on-year, after increasing more than 60 per cent last year.

Most manufacturers expect China's demand for cars to grow at 15-20 per cent for the rest of the decade, creating a market that Mr Bernd Pischetsrieder, chief executive of Volkswagen, says is on track to become the second largest in the world, after the United States.

Nor is carmakers' enthusiasm driven simply by the growth in demand. They are also making fat profits. Many cars sell for up to twice the price that they command in the US. For most manufacturers, China is now the most profitable market. Peugeot, one of the few to publish figures for Chinese operations, had an operating profit margin last year of 12.2 per cent at its joint venture in Wuhan, central China: three times as high as in its European business.

FEARS OF OVERCAPACITY

BUT the rush into China is far from a one-way bet. Even before many of the factories planned by Western carmakers have been built, fears of overcapacity and a profit-destroying price war are emerging. Mr Max Warburton, analyst at Goldman Sachs, says global manufacturers are taking 'a colossal, lemming-like leap over the cliff' as they pile an estimated US$10 billion-plus (S$17.5 billion-plus) into car factories in China over the next three years.

Just last month, Mr Pischetsrieder laid the foundation stone of Volkswagen's factory in north-east China, committing the company to double output in the country to 1.6 million cars a year, at a cost of ï¿½6 billion (S$16.5 billion). More than 3,000km south in Guangzhou, near Hong Kong, Japan's Honda is preparing to double the 120,000-unit annual production of its factory and building another, with an initial production of 50,000 a year exclusively for exports.

Nearer to Beijing, BMW is installing machinery at its joint venture with China Brilliance to make executive saloons in China for the first time, allowing them to compete with VW's successful Audi luxury operations. Japan's Toyota and Nissan are also stumping up more than US$1 billion each to open plants in China later this year. Toyota aims to have a 10-per-cent share of the passenger car market by 2010, up from a negligible level now.

China's car sales are still low, at 1.2 million last year. But the lure for these carmakers is the nascent Chinese middle class. With average annual income of around US$4,000, they now number more than 100 million and are expanding quickly.

A market once dominated by cash purchases by government agencies is now being driven by private citizens, increasingly buying on credit. Take Ms Ji Lujia, for example, a young Shanghai mother working for a technology company. She and her husband recently took out a three-year bank loan to buy their first car for 100,000 yuan to help ferry their child around and do the shopping. Already, they are thinking of buying a second car.

According to the most optimistic estimates, annual car sales by 2006 could reach between 3.5 million and four million. But by then, the multinationals' collective investment will lift China's capacity to at least 4.5 million passenger cars, three times this year's level, according to AT Kearney consultants.

The industry has learnt from its experience in countries such as Brazil of the risks of overcapacity. But no company believes it can afford to stand on the sidelines in the current period of booming profits.

'The good news is the industry is painfully aware of the hype and excessiveness of previous cases in Brazil, India and South-east Asia,' says Mr Glenn Mercer, a car-industry analyst at McKinsey. 'The bad news is that even though they are aware of this, they are probably going to march themselves into an overcapacity situation.'

The question for the carmakers and their shareholders is how damaging the overcapacity could become. Worldwide, factories are 20 per cent empty on average, and yet the industry as a whole is profitable.

In Brazil factories are half empty and the industry is in crisis. At the present rate of investment, China may be heading for a Brazil-like scenario in the short term. Prices of new cars have already begun to come down - it decreased by around 20 per cent last year. They are expected to fall even faster as production capacity grows in the next few years.

Mr Phil Murtaugh, the chairman of General Motors in China, cautions against taking the future capacity estimates at face value, pointing out that they count in full the potential output of many of China's 90-odd small carmakers, most of which are near bankruptcy. 'There are still 80 to 90 plants in China that have never built 10,000 cars in their entire history,' he says.

At Ford, Mr David Thursfield, head of international business, says the company's recently launched operations are already profitable due to strong demand and high prices. But he adds: 'We have assumed in our business model that China will have competitive margins (with the rest of the world), not these halcyon levels.'

DOWNSIDE TO PROFITS

LOOKING further into the future to measure car sales, Mr Jean-Claude Germain, chief representative of PSA Peugeot Citroen in China, points out that 2.5 million cars are sold a year to 60 million people in France, against 1.2 million sold last year to 1.3 billion Chinese. He insists investors have to keep their eyes fixed on the potential, not the short term. 'You have to talk about China for the next 25-30 years,' he said. 'But it is now that we have to invest: we are preparing the future.'

Aside from worries about overcapacity, carmakers have other reasons to be cautious. First, there is the unwelcome downside to the huge profits the car companies are making: the difficulty of getting permission to repatriate the earnings. China had agreed to ease rules on repatriating profits as part of its accession to the World Trade Organisation (WTO) but the changes have been delayed, along with a commitment to allow multinationals to establish car financing businesses. 'WTO is spelt very differently in Chinese,' Mr Pischetsrieder quipped this year.

The restrictions are bound to be eased eventually but so far, money is being taken out through underhand methods, such as overpaying for imported parts.

Another problem - perhaps surprising for those who regard China as a cheap location for manufacturing - is that vehicle manufacturing costs are among the highest in the world. Wages are very low. But the combination of a fragmented supply chain, expensive distribution networks and the need to import high-technology parts unavailable locally push costs 20-30 per cent higher than the US, according to GM.

Foreign carmakers also complain that prices for locally made parts sold to their joint ventures are often set artificially high, to the benefit of their state-owned partners who own the suppliers. Mr Chen Jinya, chairman of Delphi Automotive Systems China, part of the world's largest car parts company, says that competition is already driving down the prices of local parts and prising open the closed shop operated by the Chinese joint-venture partners and their suppliers.

'Manufacturers are putting on a lot of pressure for reductions and the government is reducing protection for the local industry as well.'

But the biggest potential problems for foreign investors stem from having to operate within an industry structure in which the Chinese state sets the rules of the game.

'CONCUBINE POLICY'

FOREIGNERS are locked into 50-50 joint ventures with their Chinese partners, with no suggestion from the government that they will be able to increase their equity stakes, let alone run stand-alone businesses. And these joint ventures have not been without friction.

Foreign companies are faced with the fact that their Chinese joint-venture partners are also allowed to enter separate ventures with other foreign competitors - a potential source of friction in an industry where advances in technology and design are guarded closely. In this 'concubine economy', each of China's top four carmakers - First Auto Works (FAW), Shanghai Automotive Industry Corp (SAIC), Guangzhou Auto and Dongfeng Automobile - has ties with at least two global manufacturers. 'That (structure) separates China from just about every other country in the world,' said Mr Michael Dunne of Automotive Resources Asia, a car consultancy.

There are signs that foreigners are starting to turn the tables by taking the initiative to establish multiple partnerships themselves. This sends a signal to existing partners that they cannot count on an exclusive relationship. Toyota, which has an agreement with FAW, is talking to Guangzhou Auto to make Camrys, while Honda and Dongfeng have just agreed to make a small offroader, even though Honda already has a joint venture with Guangzhou.

Theft of intellectual property rights, a problem endemic across most industries in China, is another source of tension within joint ventures. Earlier this month, Toyota sued Geely, a local manufacturer, claiming it copied Toyota's logo on its Merrie saloon. GM is investigating the QQ mini-car made by Chery, a local company part-owned by SAIC, GM's own joint-venture partner, for allegedly pirating the design of its Chevrolet Spark. And VW, which is also partnered with SAIC, discovered two years ago that Chery's main model was not only a direct copy of its Jetta, but used original parts. Chery switched to using non-VW parts after VW complained.

As China begins to deal with its obligations under the WTO, all manufacturers expect copyright and trademark laws to be strengthened and counterfeiting to be reduced.

But it is hard to see how the world's big carmakers can stop their Chinese partners from turning into rivals. China clearly hopes its companies will absorb expertise from foreign investors and use it to launch their own competitors. In an internally circulated draft of the state's new car policy, officials suggest that by 2010, half of the intellectual property of cars built in the country should be of Chinese origin. How this will be defined remains unclear. Some observers believe investors are not giving this protectionist policy enough attention.

NURTURING A GLOBAL COMPETITOR?

MR GRAEME Maxton at Autopolis, a consultancy, says: 'The car companies which are investing heavily are often choosing to ignore this (policy) because it doesn't fit their purpose, or they are arrogant enough to assume that it doesn't matter.'

If multinationals with operations in China do have concerns, they are difficult to detect. 'The policy is very vague to me,' says Delphi's Mr Chen. 'When I look at it, I ask, 'What's the definition of local content, and ownership of IP in this sense?' ' Mr Murtaugh, of GM, says Chinese government officials have made it clear that his company's joint ventures in Shanghai and elsewhere are regarded as local companies.

Chinese carmakers still have some way to go before they can be fully competitive with multinationals. Local companies have only 10 per cent of the market today. Their spending on research and development is a fraction of that at Western companies. Production costs remain too high. And the local market is still too attractive to make a focus on exporting worthwhile.

But by the time foreign carmakers' over-investment in China brings the current bonanza to an end, they may find they have nurtured a formidable new global competitor. 'I am worried the industry is acting as a midwife to a low-cost exporting industry that the global industry just doesn't need,' says McKinsey's Mr Mercer.

Mr Dunne of Automotive Resources Asia believes divorce between the foreign companies and their local partners is highly likely and could be messy. 'Intuitively, the Chinese believe that one day they will buy out their foreign partners. And intuitively, the foreigners think they will buy out their Chinese partners. So crunch time will come, but today is just sensational, as everyone is making money hand over fist,' he said.
Copyright @ 2003 Singapore Press Holdings. All rights reserved.

Hahaa. I long to see that day. Volkswagon turning into a Chinese company. Whahahaaaa