Pushed Toward MergersFlat car sales may hasten consolidations in China

The way China's central government sees it, the coun-try's fledgling auto industry eventually will compete on the world stage if it merges its multitude of auto manufacturing firms into a handful of giant companies. Though such talk surfaced more than a year ago, little movement has yet been seen in that direction.

But now there's a new urgency prompted by a series of auto industry merger proposals - led by the merger of Daimler-Benz AG and Chrysler Corp. - in the U.S. and Europe, which are expected to create a small but elite group of international market leaders.

Against this paradigm, China's auto sector in 1998 was flat, falling short of an expected 3% increase. Hit by weak market demand and stockpiles left over from 1997, the industry is expected to post a zero growth year. The country officially produced 1.6 million vehicles, state figures show, including 610,000 heavy trucks, representing an 8.5% fall from 1997, and 507,000 passenger cars - down 5.3% year-on-year. Industry profits, estimated at $414.4 million, reportedly were sharply down 55.4% from the previous year.

Experts attribute the poor performance to the state's unprecedented campaign to slim down its employee ranks by half last year, forcing government departments, the country's major institutional car consumers, to largely cut their purchasing budgets.

Domestic makers were forced to pin their hopes on private buyers, an area that actually saw momentum in the early part of the year. But worry of an uncertain economy, coupled with the costs of new vehicle regulations, plus new road and fuel taxes, made the car buying public wary, prompting a devastating price war among car companies.

In '98's first nine months, car sales rose by a mere 3.65%, compared with 27% a year earlier. The sale of minibuses grew by 14%, nearly 16% lower than the 30% rise a year earlier. Sales of the Red Flag, a luxury Audi-based model, and best-selling Volkswagen Santana cars, targeted for institutional users, dropped by 22.31% and 0.63% in the first eight months.

Pent-up demand found a way of revealing itself, however. While passenger car sales stalled, demand for cheaper, more fuel-efficient mini-vehicles sped ahead, helping to support the flagging industry's status quo.

Not surprisingly sales grew for farm vehicles, which cost half as much as conventional light vehicles, are easily repaired and are not held to the same government safety and environmental standards. China reportedly has 15 million registered farm vehicles, 500,000 more than the number of total registered automobiles.

Yet, despite the government's promise to invest $1.3 billion in the auto industry by the end of the century, fear of adding to China's growing unemployment problem, lack of technical proficiency and regional protectionism continue to contribute to the lack of merger momentum.

Zhang Xiaoyu, deputy director of the State Administration of Machine Industry (SAMI), admits the industry is scattered and weak. In light of last year's decline, he says there is no way that China will meet the ninth Five-Year Plan's annual production goals of 2.7 million vehicles, including 1.2 million cars, by 2000.

The central government's rationale up to now has been that lack of capacity and supply side problems were the main constraints to market development. For the last two years, however, excess capacity has become a key concern, based on a dawning realization that demand is not going to grow enough to absorb state-dictated production increases.

That said, the government plans to up the vehicle production quota in 1999 to 1.73 million units. To encourage consolidation, Zhang's department plans to develop three large companies and a dozen major manufacturers. SAMI Director Shao Qihui defends the concept, saying if China is finally allowed into the World Trade Organization, it only will have a few years to upgrade its auto industry to compete with international rivals.

Not everyone agrees. "The vision that shapes China's vehicle policy is decades behind the reality of the industry," says Kenneth DeWoskin, a University of Michigan professor and authority on China. "China continues to cling to the fantasy of creating a strong national industry. Where, in an era of global car companies, will China's national companies export?" U.S. auto executives in China say that while industry restructuring is necessary, domestic makers can't survive in the global market on their own. Mergers, in and of themselves, they say, will not solve the problem because Chinese companies lack both technology and funds to create world-class vehicles, particularly with Beijing pushing stringent emissions and safety regulations.

No individual automaker in China can currently afford the cost to develop a new vehicle, they say, with the estimated cost of such development at $150 million. In addition, China's domestic auto companies are under government control and are burdened with an average 80% debt-to-asset ratio.

"China's automotive industry must be able to withstand competition, so it will have to work with global partners," says General Motors Corp. Asia-Pacific President Rudolph Schlais, whose company thus far is involved in 18 ventures in China, representing a total investment of more than $2 billion.

But some industry observers wonder if China's auto industry is cruising in the wrong direction. There still remains little evidence that private buyers can afford the highly stylized, high-tech, high-priced automobiles that China's top carmakers are aiming at today.

In its most recent industry forecast, Standard & Poor's DRI group says that China still is at an early stage of economic development and a low rate of passenger car ownership. Average income levels are very low and will remain so, the report says. Car ownership will remain the preserve of a minority of the population (albeit a sizable one). Regional prosperity differences aside, car density is forecast to stay at fewer than 10 cars per thousand people - even into 2008.

Mr. DeWoskin agrees, at least near-term. "Although savings is high in China, there is no clear indication that car buying is a priority," he says. Education, health insurance and residential improvement all are higher on the average citizen's list, he says.