China’s Auto Industry in Crucible of Change

“Transformation” was a word frequently bandied about at mid-October’s Global Automotive Forum in Wuhan, China, for good reason.

The country’s auto industry is nearing critical junctures on a number of fronts, from the global competitiveness of its car makers, to the survivability of its indigenous supply base, to the overall economic slowdown that is seeing pockets of China’s new-vehicle market nearing maturity.

China is facing severe overcrowding issues in its biggest cities that are forcing local governments to restrict automobile ownership and traffic. Mounting air-pollution problems and increasing demand for imported oil – expected to rise to 80% of China’s total consumption in the next decade – are fomenting political debate and heightening interest in development of alternatively powered vehicles.

This year won’t see all those issues resolved, but the 2015 agenda certainly is jam-packed and the industry is expected to witness at least some directional movement over the next 12 months, insiders believe.

“We need to formulate new strategies,” says Wang Xia, chairman of the China Council for the Promotion of International Trade-Automotive Committee. “The transformation of the China auto industry is at a critical stage.”

The pressure to evolve is heightened by slowing sales growth that had the auto sector headed toward a single-digit gain in 2014. Through November, China vehicle sales totaled 21,079,134, up just 6.2% from like-2013. That compares to a year-over-year gain of 13.9% in 2013 and a more than doubling of volume from five years earlier.

This so-called “new normal” being forged from the slowest expansion of China’s $10 trillion economy in five years, has some industry insiders a nervous.

The auto sector now contributes RMB6 trillion ($981 billion) to China’s economy and accounts for 4 million-plus direct and 40 million indirect jobs, notes Wang Ruixiang, chairman of the China Machine Industry Federation, so how the next few years unfold is of critical importance to the economy overall.

Of huge concern is the domestic auto industry’s “lack of innovation and (the) incomplete supply chain,” Wang says. “To (turn) China into an auto power, we have a long way to go. We need a roadmap; we need a more-international vision. We need a range of indigenous brands contributing to the economy.”

Growth Track Points to Interior

Less alarmed is Li Shufu, chairman of Geely Group, which acquired Volvo in 2010 and now is being counted on to be among the domestic car brands to rise up and face the multinationals head-on in China and eventually establish a beachhead in more mature export markets as well.

Li is confident the new-vehicle sales pace won’t slip below an 8% compound annual growth rate and predicts the market likely will post even healthier 10% annual gains through 2020.

GM China President Matt Tsien appears on the same page, saying, “At 10% (growth), that’s still 2 million units (in additional sales) a year. That’s huge by any standard.”

But even if that somewhat-reduced pace is maintained (China’s central bank lowered interest rates in November to help ensure it does), there are fundamental shifts in the market that will alter the landscape.

For instance, while new-vehicle demand is slowing in mature Tier 1 and 2 cities, rising per-capita GDP in some lower-tier municipalities is closing in on the $5,000-$15,000 sweet spot needed to give consumers car-purchasing power.

That shift in growth potential away from the East is driving multinational automakers into the interior. GM, for one, is making a $14 billion investment in China that includes five new manufacturing facilities there by 2018, while Ford is expanding its capacity more than 500,000 vehicles annually with two new plants to be up and running this year, one south of Shanghai in Hangzhou and one in Chongqing in central China.

“We’re paying a lot of attention to opportunities in the interior,” Tsien tells WardsAuto. “But we have for years. There’s opportunity for further expansion, for further growth, but we’re pretty well-positioned today.”

Overall, China’s population continues to shift toward its cities, with urban dwellers expected to account for 59% of the total by 2025, up from 51% today. By 2022, more than half of urban households will be considered middle-class, with household incomes of $20,000-$40,000, an increase of more than 100 million households from today.

Those trends represent a potential demand boom that should keep the market marching toward a 30 million-unit-plus level by 2030.

Growing Capacity Growing Concern

To meet that demand and keep the cash cow that is China feeding their bottom lines, multinationals rapidly are expanding vehicle production capacity through their joint ventures with local automakers. This year WardsAuto forecasts China production to rise to 25.98 million units, up 12.0% from an estimated 23.19 million in 2014, with a more modest 7.9% jump to 28.03 million in 2016.

In addition to the moves by GM and Ford, Fiat Chrysler is set to launch a JV with Guangzhou for Jeep production, while Volkswagen has initiated a “Go South” strategy aimed at adding strategically positioned capacity in order to mine China’s newest growth markets.

Volvo began plotting an expansion of its Daqing plant soon after rolling out its first XC90 CUVs in September. It also plans to ship S60 sedans to the U.S. later this year, marking the first vehicle imports into the country from China.

Meanwhile, Daimler is preparing to take output “well beyond 200,000 units annually” with partner BAIC, adding local assembly of the C-Class sedan and GLA CUV this year, while Jaguar Land Rover has linked up with China’s Chery in a $1.8 billion, 130,000-unit factory. It launched Land Rover Evoque production last year and will ramp up capacity further with output of a Jaguar sedan added to the mix by 2016.

Hyundai, which has three factories in Beijing, is planning two more assembly plants, taking capacity to 1.65 million vehicles annually.

All that new vehicle-building power has some worried. Plant utilization already is slipping, standing at just 60% for domestic brands and about 87% for foreign JVs, according to forecaster IHS, with the latter expected to drop to 67% in 2016 before settling in near 75% at the end of the decade.

“China is an extremely attractive market,” GM’s Tsien notes. “People recognize it for its size and…for a significant amount of growth still ahead. So in that kind of environment, obviously there’s the potential for some to over-invest.”

But with multinationals on a firm growth track, the bigger concern centers on the domestic brands, which have seen their collective market share fall precipitously over the past 24 months to 36%, from 41% in January 2013, according to WardsAuto data.

“We need to learn the lessons (of automakers elsewhere) and control our investment,” Dongfeng General Manager Zhu Fushou warns.

For local automakers, the market trends are troubling. A study of 2,400 domestic-vehicle owners by the Boston Consulting Group indicates only 30% will stick with a Chinese brand for their next purchase. Some owners say they’re disappointed with the quality and performance of their cars, and others intend to shop foreign luxury brands because they offer better features and after-sales service.

“Chinese drivers are far more eager to switch brands than average consumers in developed economies,” the BCG report concludes. “Success in China will increasingly depend more on automakers’ ability to keep existing customers and to lure customers away from competitors.”

Shaanxi Automobile Group Chairman Fang Hongwei sums it up bluntly: “The market situation has changed profoundly.”

Multinational Suppliers Key to Quality

But local automakers are mounting an offensive, in part made possible as more advanced technology becomes available from foreign suppliers. J.D. Power reports quality is improving rapidly, with domestic models rated at 131 problems per 100, compared with 95 for foreign brands. That 36-point gap is the smallest yet in the seven years the firm has surveyed the market.

And many foreign expats and analysts on the ground in China believe it won’t be long before a local brand or two is able to compete on equal footing with the multinationals and even begin selling cars in mature markets such as the U.S. and Western Europe.

“Wisdom is many (domestic brands) will go by the wayside. But Tier 1 (suppliers) are helping them, and with (that) help they’ll be able to (go global),” predicts Jack Perkowski, chairman of JFP Holdings.

U.S.-based supplier Delphi says it has contracts with 17 of the top 20 OEMs in China and contends domestic automakers are shifting their purchasing focus away from suppliers with the lowest price to those with the highest quality and best integration capability.

Most are signing more sophisticated strategic supply agreements, rather than basic purchasing contracts, says Simon Yang, president of Delphi China. “(Domestic OEMs) know clearly where they want to be in the future. In short, they want to be exporting to developed markets very soon. They will catch up.”

Edouard de Pirey, president of Valeo China agrees, calling the product-development growth trajectory of local OEMs amazing and comparing it to the rapid rise of South Korea’s Hyundai.

“I’m convinced one or two OEMs will become the Hyundais of the 21st century,” he says. “They (just) need system support and high quality (parts), and for that they are coming to us.”

Meanwhile the market itself is evolving with a much more Western feel. The Internet is growing in importance as a sales tool, with online buying now accounting for an 8% share of all retail in China – a higher penetration than in the U.S.

Leasing, still small at just 3% of new-vehicle sales, is growing, and far fewer buyers are paying cash for their cars, with financing now covering about 20% of sales nationwide, up from just 1% in 2000.

That’s not a small number, given a market of 22 million vehicles annually, points out Liang Goofeng, vice president at Beijing-based automaker BAIC, which has financial backing from international investor Warren Buffett and operates JVs with Hyundai and Daimler.

Domestic Suppliers at Risk

With a less certain future is the supplier sector, where domestic parts makers are struggling for survival against their multinational competitors, now firmly entrenched and growing rapidly.

France’s Valeo, for example, derives 13% of its revenue and 30% of its booked new business from China. U.S.-based Delphi has 22 manufacturing operations there, employing 26,800 people, about 15% of them engineers.

Jay Kunkel, president of Asia Pacific for U.S.-based supplier Lear, says local suppliers have a stiff challenge in trying to face off with multinationals that are bringing the full force of their global R&D and investment capability to bear. Lear now has 42 locations and 20,000 employees in China and is planning this year to open a dedicated design center for new-energy vehicles, expected to be a key growth sector.

“It’s difficult (for domestic suppliers) to close the gap because of the capital-intensive nature of the business,” Kunkel says. “How do you supplant multinationals (that already) have relationships with the OEMs, and global engineering?”

Perkowski agrees. “Local suppliers now are good at mechanical parts, but in most cases they lack electronic parts and (the ability) to put them together with mechanical parts in modules.”

The government is actively encouraging suppliers to seek mergers and acquisitions with more tech-savvy Western firms as the best avenue to survival.

Beijing has cut some of the red tape from regulations on overseas investment and is doing what it can to push any proposed deals through quickly. The central government also is conducting workshops to help Chinese suppliers find partners and is phasing out dual-tax laws that make tie-ups less attractive.

Ellis B. Chu, director and head of China M&A for Bank of America Merrill Lynch, projects $3.3 billion in M&A activity in China for 2014, with 58% of that outbound. That compares with $1.2 billion and 33% in 2012.

“We expect that trend to continue,” Chu says. “This is the most excited I’ve seen Chinese companies about wanting to go outbound.”

But Lear’s Kunkel is skeptical the plan will work in the long run.

“We’re starting to see the Chinese acquire other firms, but how will they integrate that and do they have the management talent to do that?” he says. “We see some with 20-year JVs that still haven’t transferred technology.”

Indeed, a 2014 survey by the U.S.-China Business Council shows there’s still reluctance to transfer technology. Of the U.S. businesses polled, 62% said they were too concerned about protecting their intellectual property rights to turn over technology to the Chinese. But an even higher number – 80% – said they were not even asked by Chinese partners to do so.

“Foreign companies aren’t just standing still, either – and in technology if you miss one generation you’re out of the game,” Kunkel says. “I think it would take (brilliant) leadership (by a Chinese supplier) to close those gaps.”

Electrification to Play Big Role

If there’s one area where China could emerge a leader it’s in so-called New Energy Vehicles, a group that includes battery-electric, hybrid, plug-in hybrid and fuel-cell models.

Driven by the country’s over-reliance on foreign oil – 60% of imported oil goes to the transportation sector – and smog problems that have crippled major cities such as Beijing, plus November’s carbon-reduction accord with the U.S., China could become the world’s premier market for NEVs.

Air-quality measurements taken in early 2014 had Beijing rated at 517 and Shijiazhuang at 701, well above the 300 score considered hazardous. In contrast, equally crowded London posted a rating of 30 and New York recorded a 34, both considered good.

“People are fed up with the pollution in our major cities, like Beijing,” says Wang Chuanfu, chairman of BYD, which is based in the capital and putting most of its chips on EVs and plug-in hybrids. “It’s becoming a primary issue for Chinese society.”

Overall, only about 43,000 electric vehicles were sold in China in the first nine months of 2014, accounting for less than 1% of the market, but Wang says BYD already is delivering about 1,800 PHEVs per month and by 2020 “the market is going to be huge. We believe the opportunity (for NEVs) will be unprecedented.”

Traffic congestion is another hurdle threatening to limit vehicle access in major cities and curb sales for automakers. Gridlock is “now reaching the Tier 3 and 4 cities, not just Tier 1 and 2,” points out Dongfeng’s Zhu.

Beijing and Shenzen both rated an astounding 95 on IBM’s 2012 Commuter Pain Survey, compared with London at 23, Paris at 31 and Los Angeles at 34. Only Mexico City scored worse, at 108 on the index.

“If everyone in China has a car, like in the U.S., that would be a 1.2 billion-vehicle parc. The Earth cannot take it,” BYD’s Wang says.

In a nutshell, the Chinese market and its domestic auto industry are beginning to look much the same as in the more mature U.S. and Western Europe. Competition is increasing, environmental and traffic-congestion worries are driving NEV requirements, consolidation among the supply base is accelerating and consumers continue to insist on easier ways to purchase their next vehicles.

But many here remain confident in the market’s future and believe at least a handful of China’s domestic automakers will tackle the challenges they face at home and figure out a way to be relevant on the global stage to boot.

“If 20 years from now there will be a (single) world brand from China, that would be OK,” says Geely’s Li. “But perhaps there will be two or three.”

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