China\'s automotive regulations could actually undermine the long-term competitiveness of the Chinese automotive industry.
Just as the automobile is one of the most regulated consumer products in the world, the automotive industry in nearly every country is subject to a range of formal and informal measures that influence the industry’s development. Because the industry is considered a “pillar industry” in so many countries, these measures are, naturally, intended to benefit the individual nation’s economic development. In China, one particular measure is emblematic of the country’s approach to influencing the industry: the requirement that foreign vehicle manufacturers enter 50:50 joint ventures (JVs) with the local manufacturers for their manufacturing and assembly operations in China. But how well does the 50:50 rule support the creation of a competitive industry in China and long-term economic development?
In our view, China may be at risk of creating an environment that will fall into the same trap over the long run as many other countries that have tried to protect ownership or access to markets for domestic players. It may create systemic weaknesses that will ultimately undermine the very objective—a strong automotive industry—that the government is trying to pursue.
The economic impact and future potential of the Chinese automotive industry is so obvious that it hardly bears discussion. China is already the second-largest auto and truck market in the world, based on unit sales. Further, there is a clear expectation that China will ultimately be the largest market in both production and sales, at least on a unit basis. In highly developed auto markets, such as the United States and Germany, auto industry directly or indirectly accounts for as much as 10% to 20% of total employment; there is every reason to assume the same will be true for China.
From the standpoint of product quality, the vehicles available to consumers in China are, in many cases, the same or slightly modified models being sold in developed markets today. Even better, consumers are getting more value for their money as the purchase prices for popular models decrease in response to increasing competition and economies of scale that are driving down costs.
In terms of profitability, most foreign vehicle manufacturers (VMs) are seeing margins above those in many other markets. While we can expect a likely reversion toward mean profitability over time, consistent with the cost of capital, early results have been promising.
China is also increasing its likelihood of becoming a future innovation engine for R&D, as more and more investments are made to develop Chinese-branded vehicles for the China market as well as for export. We can expect China to become a leader over time for classes of vehicles that will have significant demand in China and for current applications of vehicle technology.
Finally, China may also become a key source of groundbreaking future technologies, such as alternative drivetrains, that would benefit society as well as the industry by reducing emissions and cultivating new sources of energy. If this development comes to pass, it is likely to occur with some assistance from the Chinese government, which is attempting to address major challenges in energy shortages and the environment.
The industry did not rise to where it is today by accident. The government has carefully and deliberately managed the regulatory environment to nurture the industry on its growth path. At the risk of oversimplifying the basic policy strategy, the government in effect offered market access to multinational corporations (MNCs) in exchange for technology benefits, as foreign VMs established 50:50 JVs with local VMs. The rationale was that this form of ownership and control would strike a balance that would support overall growth and innovation in China itself, while also meeting the needs of foreign VMs’ shareholders for profits.
In arriving at this and other auto policies, the Chinese government has carefully balanced a fundamental policy tension between what could be called membership in the global automotive industry versus the development of a Chinese national automotive industry. The nature of these ultimate scenarios and the associated regulatory policies that would get the industry to reach them would effectively influence the industry to grow along different developmental paths.
Membership in the global automotive industry, for example, emphasises Chinese VMs developing strategic relationships with global VMs and becoming part of their global supply chains, while supporting localisation of components in China as well as localisation of products, to the degree that provides Chinese consumers unique offerings. Also, Chinese partners should be naturally advantaged in sales and distribution in the long-term, due to their knowledge of the Chinese market and Chinese consumers.
By contrast, a more Chinese national auto industry would be characterised by JVs with foreign partners and a strategic direction for the industry in China itself that would be significantly controlled by Chinese government, with the development over time of a local supply base and with policies that favour Chinese ownership and control of the industry. This would create an opportunity for domestic VMs to establish advantaged positions versus foreign VMs and suppliers—potentially at the expense of economic efficiency across the global auto industry itself, but with distinct advantages for local Chinese players and perhaps for China economically.
The size and focus of investments in China and the types of capabilities that would ultimately be developed in China by foreign and domestic VMs are dependent on which of these different policy objectives the Chinese government pursues. However, rather than coming down on one side or the other, it’s clear that China has been trying to develop policies that allow China to be a member of the global club while developing a strong domestic auto industry with Chinese characteristics. In developing its policy, China has undoubtedly drawn on the experiences of Japan and Korea, which have been successful in building strong industries, as well as heeding warnings from Malaysia’s mistakes.
China’s attempt to guide the development of its automotive sector has not always gone smoothly; nor has it yet resulted in an industry as focussed and competitive as was originally anticipated in the development plans of the mid-1990s. For example, an original theme of industry development was the notion of consolidation around three designated State-owned Enterprises (SOEs) in partnership with selected foreign partners. However, smaller provincial companies have proven more resilient than anticipated, while the established companies have had a hard time reforming their high cost structures. Indeed, the first exports from China into the global market are most likely to come from a group of second tier players not originally seen as major competitors.
Similarly, consolidation and rationalisation of the auto component industry have taken longer than anticipated and the largest Chinese producers still have a high degree of vertical integration or hard-to-alter informal, local supplier networks. Unlike the auto industries in Korea and Japan, China’s auto sector has been slow to achieve the consolidation and scale necessary to drive costs down; the large scale multifaceted parts makers and assemblers present in Korea, Japan or even India remain to be seen in China. Time and again, the national policy for a rationalised industry has been subverted at the provincial level. Several smaller provincial competitors, largely out of the scope of the national policy, have shown themselves to be nimble and aggressive competitors.
China’s first official document governing the automotive industry, the “Auto Industry Policy in 1994” was released as part of the country’s ninth Five-Year Plan. The 1994 document was a typical product of the planned-economy era, focusing mainly on setting up key economic and operating targets, as well as the mechanisms that monitored and adjusted these targets.
After 10 years of a strategy in which China swapped market access for technology, in the form of joint ventures, the government revisited and revised policies to make them more market-driven and also to make them fall in line with the philosophy of “balanced development” that the current cabinet has adopted.
In 2004, the government introduced the new Auto Industry Development Policy, which showed a clear shift in emphasis on several key dimensions. The one feature that stands out is the requirement that foreign VMs operating in China do so in 50:50 JV with domestic companies: This 50% cap on foreign participation in vehicle assembly was highlighted in the 2004 China Compared to other Governments. Policy much to the surprise of industry observers who were anticipating its abolition. Other elements include:
Building a stronger national industry and
domestic companies versus reliance on JV partners to drive development
Realising that the JV approach had achieved many of its initial objectives, the government shifted its focus towards growing the intellectual content created and value added by Chinese companies. To do so, the government recommended an increase in proprietary brands, proprietary technologies, and proprietary vehicles. Recent moves by Shanghai Automotive Industry Corporation (SAIC)—such as the 2006 launch of the Roewe, based on the MG Rover 7, and First Automobile Works (FAW) including the 2006 launch of the upper middle Besturn—are examples of the State-owned OEM groups’ endeavours that are in line with this policy objective.
Creating a competitive industry structure
There are still far too many small VMs and suppliers in China. Recognizing the likelihood of decreasing profitability in the auto industry, and potential overcapacity looming on the horizon, the 2004 policy encouraged both domestic and foreign parties to join forces in consolidating China’s auto industry and improving overall productivity. The means for doing so, however, like many government plans, remain unclear.
Increasing corporate autonomy
Recognizing the limits of the government in efficiently managing the auto sector, the new plan encouraged consolidation of the ruling government bodies and functions, lowered entry barriers to further encourage participation from the private sector, simplified approval processes, and attempted to standardize how decisions are made rather than requiring approvals for every decision.
Going global
The plan encouraged global expansion to support the growth and overall health of the industry. This element of the plan included providing various forms of support for VMs to export end products, and suggesting that 15 percent of leading SOEs’ revenue should be generated from the export of parts and components by 2010.
Enforcing compliance with WTO mandates
In accordance with China’s 2001 entry into the WTO, the industry must begin to comply with the elimination of restrictions regarding local content, import quotas, and export quotas.
Encouraging sustainable development
Fuel efficiency: 15% overall improvement by 2010 (against 2003) levels for all passenger vehicles produced in China. Government endorsement for the development and commercialization of alternative powertrain and vehicle, e.g., hybrid, diesel, hydrogen/fuel-cell, pure electric etc.
In our WTO-related work for the Shanghai government in 1999, we outlined two fundamental arguments that we continue to believe will guide the Chinese automotive industry. First, the industry is truly global and operates under a certain set of rules, driven by the economics of supply and demand. Second, over the long-term, China (while important) cannot change these rules. Globally, the industry itself is too large for China to do this. However, within the rules, Chinese companies will likely have unique advantages in operating within China.
In this context, we see a number of issues that indicate that global economic realities and the recent experience of Chinese companies do not support the current 50:50 JV structure.
Impact of technology transfer
Technology transfer was one outcome that the Chinese government hoped would result from the 50:50 requirement. However, it’s not clear that technology transfer has really taken place at the levels originally envisioned by the Chinese government or by the domestic VMs. We hear a common refrain that foreign VMs continue to keep much of their best technology either out of China or on the “foreign” side of the JV. Given the persistent problems in protecting Intellectual Property Rights (IPR), the foreign VMs are doing what they can to protect their intellectual property while waiting for the legal system (de jure and de facto) in China to come up to speed and address the IPR issue. While IPR protection is technically not an issue related to the 50:50 rule, there is scant evidence that Chinese JV partners have been able to convince their foreign partners that they can significantly reduce the risk of IPR theft by leveraging their own relationships with the Chinese government.
Impact of 50:50 ownership on partner profitability
Foreign JV partners’ ability to develop China as a source for assembled vehicles or even components is being thwarted by the requirement to split profits with local partners that may have been adding little value to the export sale. While the 50/50 venture may be appropriate for the domestic market, where partners bring infrastructure and distribution capability, it makes China sourcing of fully assembled vehicles unattractive for the export market. The answer is, of course, to have a Wholly Owned Foreign Enterprise (WOFE) working in tandem with the original JV. Unfortunately, approval for these companies has been slow in coming.
Development of Chinese brands and companies
The leading brands in China today are mostly foreign brands. Among the domestic players, Cherry and Geely are making significant inroads with other domestic players starting to have an increasing impact. In terms of building brands, the JV structure has to some degree reduced or at least delayed the need for Chinese VMs to develop their own independent brands. This is not only an issue of brands, but really a broader issue of developing world-class Chinese MNCs, which can compete on an equal footing anywhere in the world. Few Chinese companies, let alone domestic VMs, have achieved this status.
Chinese development of global management capabilities
Chinese companies’ early forays outside of China have provided a window into how Chinese executives have developed their global management capabilities in their association with MNCs. One of the recent ventures abroad has been SAIC’s acquisition of Ssangyoung Motors of Korea. While we should be careful about drawing too many conclusions from this experience, it highlights some of the gaps in global management skills that may still persist.
To date, the acquisition experience has been rough, with SAIC now wrestling with labour unions and their expectations—something that SAIC had not experienced in China and for which it was not prepared. Industry observers believe that some of the reasons for these struggles can be attributed to a lack of understanding of how to work in Korea, especially within the Korean culture, and insufficient experience in operating in offshore markets in general. After a rough start, SAIC sent in newly hired Phil Murtaugh, the veteran GM executive who largely led GM through its rapid growth years in China, who clearly brought significant international management experience and culture to bear. News out of Korea has been increasingly positive in recent months, which is likely due to the ability to bring greater MNC management experience to bear.
By contrast, GM’s takeover of Daewoo in Korea, while somewhat different in nature than the Ssangyoung deal, was a success from a process management perspective from day one. At the time of GM’s takeover, many industry observers in Korea were skeptical about whether GM would be effective, citing some of the same issues related to labour unions that are now affecting SAIC’s acquisition of Ssangyoung. It’s tempting to speculate about how GM’s global management experience and skills, acquired through decades of operating abroad, helped guide its actions with Daewoo. Given GM’s success, and SAIC’s JV with GM in China, the obvious question is: To what degree should the JV relationship have helped build the capabilities that would have made SAIC similarly successful in its investment in Ssangyoung?
The need for strong automotive companies in China, with Chinese ownership and characteristics. Chinese VMs are beginning to compete with their own joint ventures. SAIC recently announced the launch of its own vehicle under the “Roewe” brand, and is actively building awareness of the brand with consumers. At the same time, SAIC maintains JVs with GM and Volkswagen, which sell vehicles that will compete against the Roewe. Technically, this need not dilute SAIC’s focus or that of GM or VW, and brand competition under a single company is not uncommon in the auto industry. At the same time, the risk is that domestic VMs, like SAIC, could increasingly start looking like holding companies, with a portfolio of different relationships based on control over assets, but with less of a focus on building winning capabilities related to developing, branding and selling the best cars for the money to increasingly choosy Chinese consumers.
Finally, lessons from other industries suggest that JVs have significantly declined in attractiveness as a means of participation in the Chinese market. In a recent study of more than 40 foreign companies operating in China, 95 percent of the respondents said that they would prefer to be WFOEs. The key reasons: greater control and transparency, the ability to retain financial rewards without having to share with a partner that brings less to the table, a reduced need to protect IPR, and a decreased need for guanxi.
China should perhaps take note that the key to developing its foreign JVs as active exporters is to permit greater foreign stakes, as in India and Thailand. While both of these countries have far smaller auto sectors, they are much more successful exporters.
China’s entry into the WTO provided a set of boundary conditions on the rules of play, and has ushered China into the global automotive community. The series of Five-Year Plans have also guided the industry to an impressive state. But growth in the future will require taking a closer look at how well the industry is structured for success, and paying more attention to the softer issues related to industry development.
Beyond the short term arguments—many of which are credible—for giving Chinese automakers time to develop before competing on their own, the fundamental issue is one of economics. The overwhelming evidence supports the fact that in the long-term, free markets driven by consumers and producers enjoying unconstrained ownership and facing market-led competition build the foundation for the most efficient allocation of economic surpluses, and that this is done most efficiently through the price mechanism—not through artificial props for the economy, driven by government policy The Contrariancorner. From another perspective, the question is whether there is a more efficient set of economic policies that would better support the development of the automotive industry and overall economic impact on China than the 50:50 rule. But at some point in the future, it will be clear to the Chinese government, and to everyone else, that the 50:50 JV rule has outlived its usefulness.
Keywords: Chinese automotive industry, Chinese national automotive industry, China's Auto Industry Development Policy , 50:50 JV, Chinese vehicle manufacturers, World Trade Organisation (WTO), Intellectual Property Rights (IPR), Technology transfer, Shanghai Automotive Industry Corporation (SAIC)
