First it was textiles and consumer electronics. Next may be cars. China is once again looking to target a key consumer market in the U.S. Yet while low wages and government support could ultimately make China a powerhouse in the global automotive industry, Wharton faculty and industry analysts say it will take some time to reach that goal.
China needs at least another decade, according to these analysts, to overcome a long list of obstacles, including poor quality, high costs, weak design and a lack of distribution networks, before Chinese companies can compete with Japanese and Korean carmakers. “Whether they will be able to get their tentacles out there and do what the Koreans are doing is the question. There’s no reason to believe they won’t; the question is when,” says Wharton management professor Marshall Meyer.
So far, Chinese exports are only trickling out to a few spots in Europe, Southeast Asia and the Middle East, but the chairman of DaimlerChrysler has confirmed that the company is in negotiations with companies in China and elsewhere to manufacture DaimlerChrysler models abroad for export to North America. And entrepreneur Malcolm Bricklin has said he will import cars made in China by Chery Automotive Co. to the U.S. in 2008 or 2009, although that timetable has already been pushed back twice.
China’s first problem in becoming a major exporter is quality. Last year, the European New Car Assessment Program, which monitors auto safety for governments on the continent, gave its lowest score ever — zero — to a Chinese SUV.
“I don’t really see that the U.S. will emerge as a significant market for Chinese exports in the next five to 10 years. There will be some low-end Chinese imported cars, but these products have to overcome stringent regulatory standards, appeal to a demanding U.S. customer base and develop viable distribution channels,” says John Moavenzadeh, executive director of the International Motor Vehicle Program (IMVP), an industry research consortium based at Wharton and MIT. “On the other hand, I don’t see any reason why we shouldn’t expect Chinese imports over the long term. We have witnessed a clear pattern of increased imports followed by increased U.S. production capacity — the rise of the transplants — for Japanese and Korean manufacturers.”
China currently has 120 auto manufacturers, including 12 major players. Last year it sold nearly six million vehicles, mostly in the domestic market, surpassing Japan as the world’s second-largest auto market behind the U.S., where 17 million cars are sold annually.
A Game of Musical Chairs
In China, there are two types of auto companies: joint ventures operating with the world’s major auto producers, and homegrown firms, including Shanghai Automotive Industrial Corp. (SAIC), Geely, Chery and First Automotive Works, the country’s oldest car maker.
Wharton management professor John Paul MacDuffie, who is co-director of the motor vehicle program, says China’s own domestic market should be the focus for now. Chinese domestic sales increased 47% in the first half of 2006 over the same period a year earlier, while sales in the rest of the world were essentially flat. “The incredible growth rate for the Chinese industry is in China itself.”
MacDuffie, too, says it is a question of when, not if, Chinese vehicle manufacturers eventually attempt to export into foreign markets. The speed of international acceptance will depend on whether China can avoid the same type of quality problems — such as rust and rattling parts — that initially tainted the reputation of Japanese and Korean exports, leading to U.S. consumer dissatisfaction that delayed the penetration of overseas markets for years. “There was a long period of retrenchment and rebuilding after leaving that bad impression,” says MacDuffie. “The Chinese companies will have to be wary of repeating that. If anything, American consumer standards for quality have only gotten higher.”
Another obstacle to China’s export potential is a new generation of low-end subcompacts developed by Japanese and Korean companies that are performing well in this traditional entry-level export sector. “Nissan, Toyota and Hyundai have new and terrific products,” says MacDuffie. “They are not as cheap as the Chinese product, but what they offer in quality and fuel efficiency for $10,000 to $12,000 is very high.”
According to Meyer, stagnant growth, combined with overcapacity and consolidation in the global automotive industry, may limit China’s ability to push forward as an exporter compared to the Japanese and Koreans who came before. He likened the global auto market to a game of musical chairs. “When the music stops, how many chairs will be left? Will there be room for a Chinese brand to sit?”
Chinese government policy will also play a role in the nation’s efforts to become a world-class auto exporter. The central government in Beijing has identified the auto industry as a “pillar” of the nation’s economy and offers incentives and protections to domestic producers, although import duties have dropped significantly since China joined the World Trade Organization in 2001. Foreign automakers are limited to a 50% stake in Chinese producers for the domestic market, but there is no limit on ownership of export operations.
Meyer notes that the government also supports its auto parts industry, which needs to undergo additional development before China can grow as an exporter. To speed up that process, China is bringing together vehicle assembly and parts production in special economic zones to improve productivity in automobile manufacturing. The country is going about this very intelligently, Meyer says, “connecting the industry in geographic areas and building the infrastructure and supporting industries to create a powerhouse.”
This month, the U.S., European Union and Canada formally petitioned the World Trade Organization to prohibit Chinese duties on imported car parts, which they say are hampering foreign carmakers in China. The complaint alleges the government requires foreign carmakers to buy at least 40% of their parts from local suppliers or pay almost double the import duty applied to assembled vehicles.
Will China attempt to get a toehold in western markets through its own acquisition of a struggling U.S. automaker? Not likely, says Meyer, although he points out that SAIC acquired a major stake in Korean auto manufacturer Ssangyong Motors in 2004. He does not expect to see a Chinese firm go after a company like Ford in the wake of earlier U.S. resistance to Chinese acquisitions of Maytag and Unocal.
No ‘China Price’
While government involvement nurtures the industry in some ways, it may also hamper the development of China’s auto industry, says Moavenzadeh. State and municipal governments own many of China’s leading auto companies, including SAIC. As each city and region promotes its own auto projects, a coherent and profitable central policy is difficult to enact. “Everyone has this notion that the Chinese government is a great, powerful, monolithic central entity that calls all the shots, but in reality, China is a highly-fragmented political structure,” he says.
And while many other industries have done well by exploiting the country’s labor rates to export at a rock-bottom price, the auto industry does not lend itself to a so-called “China price” — at least in the near term. First, shipping costs are significant when it comes to autos, which include dead airspace, compared to t-shirts or compact disc players. In addition, commodity prices and the costs of developing automotive technology and research capability weigh on China’s car manufacturers when it comes to price.
Susan Helper, an economics professor at Case Western Reserve University’s Weatherhead School of Management and an IMVP researcher, says Chinese engineering and manufacturing expertise is not yet developed enough to build a sophisticated, integrated product like a car at an affordable price. A car is different from a PC, which can be assembled in a modular format based on standard parts.
In addition, Chinese government policies that limit public organizing and freedom of association have kept wages low, benefiting the multinationals working with Chinese joint-venture partners. That could always change, Helper suggests. “There’s an uneasy cooperation between the government and the multinationals. The multinationals don’t want wages to rise, but many in the Chinese government have a paternalistic desire to see the standard of living improve in China.”
Jianxi Luo, a doctoral student at MIT and an IMVP researcher, says automakers consistently underestimate the cost of producing cars in China. “In automotive, there is no China price,” he says. “For international joint ventures there are very high sourcing costs at this stage because they need to import critical parts from abroad or invest in educating their local suppliers. On the other hand, for the Chinese local automakers, they have to purchase technologies or outsource research and design to international developers.” He suggests that a few exporters may try to import a car to the West in the next two or three years, but it will be only a token effort. “The key problem is that China has no secret weapon, no competitive advantage.”
Over time, however, he predicts that China will get a handle on auto costs, at which point its advantage in labor will allow it to become a very competitive global auto exporter. “I still believe Chinese cars can sweep the mature markets, but it’s a long [ways off].”
According to Moavenzadeh, China’s strategy of developing automotive research and development capability through joint-venture requirements has had only limited success. In some cases, China has relied on blatant reverse-engineering to copy western designs, only delaying the true transfer of knowledge needed to build a highly complex, integrated product. In 2004, General Motors filed suit against Chery over its QQ model, which GM said was identical to the Spark manufactured by GM’s Korean subsidiary Daewoo. The lawsuit was eventually settled.
“For the most part, the capability of how to design and engineer vehicles has not transferred,” notes Moavenzadeh. “That’s not to say the Chinese haven’t learned a lot, but the real research and development process has not transferred as efficiently as the Chinese government hoped.”
Luo says Chinese auto manufacturers are just now beginning to pour money into research, hiring experts from around the world to help develop new cars. China took a similar route in telecom with Huawei Technologies Co., which was once best known for ripping off Cisco Systems’ designs. Huawei has since invested $558 million in research and development and now employs 7,000 engineers. Last year, it recorded $8 billion in new business, including contracts with British Telecommunications PLC. Chinese automakers no longer engage in copying and reverse engineering, he says. “Having earned enough money in the past few years to spend on R&D, they don’t need, and don’t want, to copy any more.” Luo notes that as part of China’s outsourcing initiatives, Chery cars have bodies designed by Italian Pininfarina, chassis engineered by British Lotus and engines calibrated by Austrian AVL.
Learning the Science of Branding
Even if Chinese automakers can learn to develop and manufacture high quality products at a low price, they will still need new business models to market and distribute export vehicles. “The key challenge for China is getting the product right,” says Ronald Haddock, a vice president of Booz Allen Hamilton in Shanghai. “The auto industry is saturated with products in every segment. The question is, which category will the Chinese fit in? Whose market share will they take?”
Chinese automakers must also carefully decide where to target their first exports, Haddock adds. “Would it make sense to enter the most challenging market — the U.S. — or learn in other markets first, like Syria, Iran or Iraq?”
Distribution will be yet another challenge for Chinese firms. Chinese exporters must consider whether to build their own dealerships, which Haddock says can be extremely expensive. One advantage the Chinese have over earlier Asian exporting nations is that U.S. auto dealers are now comfortable carrying several brands in one location. Another possibility for Chinese companies would be to sell through low-cost dealers like AutoNation.
In addition, branding is a totally new concept the Chinese will need to master, says Haddock. “Branding is a relatively new science in China, and until people learn how to brand every element of a vehicle and decide who it should be targeted to, they are at risk of putting a product out that doesn’t stand for anything.”
Finally, he says, Chinese auto exporters will face organizational challenges in creating and operating a global business structure. The ultimate challenge may be developing a sustainable auto industry in a country where a massive and sprawling population could choke itself off with air pollution and gridlock if auto ownership increases to the extent it has in North America and Europe.
Still, Helper expects demand to continue in China, despite Western concerns about the environment. “China quite rightly has said, ‘You shouldn’t ask us to not develop because you have messed up all the air,’” she says. “There are going to have to be drastic changes made in terms of how we use energy, and the transportation sector is a big piece of that. It’s going to affect total auto demand and will, to some extent, affect where the cars are made.”