In October 2013 sales in China reached 1.92 million units – see the China Auto Industry Association statistics page for details. That's just shy of a 24 million unit rate, and is surely the largest number of vehicles ever sold in a single market in a month. For GM, sales were 282,000 units – 25% more than US sales that month. Everyone is in the market, or preparing to enter there. The Korean neighbors (Kia and Hyundai, but also Daewoo as part of GM), Japan (or at least the Japan Three of Toyota, Honda and Nissan, and Mazda and Suzuki), Germany (BMW, Mercedes, VW), the Detroit Three and now the French, both PSA and Renault. A host of local firms continue, though most as paper entities. Still, Great Wall, Chery, Geely, BYD, Changan and others.
This raises a host of questions. I focus on two: geography and profitability. I frame my brief analysis using the perspective of the OEMs. Since more and more value added lies with suppliers, that may lead to inappropriate conclusions, but for now I will accept the status quo terms of debate.
...the geography of China's automotive industry makes no economic sense...
First, despite very large production volumes, a side effect of government policy has been to disperse production widely. Even though the Third Front policies of the 1960s are widely understood to have been a failure, the political economy of joint venture approvals has led to factories in locations that make little sense. Today, with the market supply-constrained, that matters little. As competition heats up, however, the costs that accompany scattered locations will become more and more burdensome.
Second, there's profitability. On a global basis, the dark secret is the industry depends on the US market for a disproportionate share of profits. Japan's domestic market is in long-term secular decline, and will remain fundamentally unprofitable despite the dominant position of Toyota. (Suppliers seem to be able to collude with impunity – or so they thought – but Toyota hasn't been successful in being a price leader.) Europe is little better, offset only because of a richer product mix. How profitable is China? To my mind that is the single more important strategic variable the industry faces.
Back to geography. Under Mao local governments were expected to fend for themselves, first and foremost in terms of food but extending to a wide variety of industrial products. Fearing a Soviet attack, Mao deliberately dispersed heavy industry into remote locations. So at the onset of post-Mao reforms, every province and most large cities turned out trucks and passenger cars, even if only a handful a year. In total there were perhaps 120 producers. But political power was likewise dispersed; up-and-coming party officials were rotated through a variety of posts, but anyone slated for top leadership served a stint as a provincial governor or mayor of a prefectural-level city such as Shanghai. To be promoted to the senior leadership in Beijing required presiding over economic growth. So when the government looked to joint ventures to improve motor vehicle production, the result inevitably was one factory here, another there. Local protectionism – in Shanghai you found old generation VW Santanas, in Beijing you found jeeps – reinforced this desire to have your own plant.
China has no equivalent to the 600-mile-long I-75 "automotive alley" in the US, with an agglomeration of suppliers, assemblers and associated engineering centers feeding off of each other in a positive manner. Beijing is 1,300 miles from Guangzhou [Canton] in the south, and several automotive operations are another 400 miles to the northeast of Beijing. Similarly, at the western end of the zone is Kansas City, 700 miles from Detroit and 650 miles from Columbus, OH; Chengdu in the Sichuan basis is 1,200 miles to the west of Shanghai, across rough terrain, and Urumqi is 2,400 miles away.
Perhaps Wuhan will become a nexus – a recent Automotive News China story – but there is none at present at the assembler end. Perhaps suppliers are more concentrated, I know of several engineering centers in Shanghai, proximate to those of VW and GM, the two largest car companies in China. But what this means is that as competition heats up, and the segmentation of the country into regional markets eases, there will be numbers of plants whose location will saddle them with high logistics costs coming and going. As long as the government mandates joint ventures, politics will trump sensible plant siting. The geography of China's industry makes no sense, and will cost firms money.
...GM's & VW's Chinese ventures appear to be quite profitable....
Then there's profitability. Perhaps some suppliers break China out as a separate geographic region, but I've yet to find any. (My understanding is that parts suppliers are not under the stricture of forming joint ventures, though likely many of them have because local partners add value.) Assemblers however are limited to joint ventures, and at the two market leaders (GM and VW) their profits are accounted on an equity basis, rather than as part of normal operating profits. Both however provide that number. It's likely to be an underestimate. The biggest potential divergence would be if these ventures paid dividends; that would reduce retained earnings and the rise in book value. That is, equity income falls, though it would be offset by dividend income. However, neither media reports nor financial statements provide any hint of such payments. Indeed, it's clear that at present all funds are being reinvested. Instead, the (post-tax) equity income is an overstatement because both venture partners have an incentive to use transfer pricing to the hilt, as they get 100% of any excess, but only half if they let the venture book a lower price and higher profits. On the Chinese side that includes the provision of real estate; for VW and GM it would include licensing fees for intellectual property. Both firms have relatively new facilities, and continue to invest at a prodigious pace; they likely have high offsets for depreciation. And of course GM and VW can only report half of total profits.
To the numbers: in the first 9 months of 2013 GM International Operations, under which China falls, realized equity income of $1.4 billion; total consolidated GM profits were $4.3 billion, so the Chinese joint ventures accounted for 32% of the total (and 32% of unit sales). Another way to view the China side is to compare profits in North America with profits in China. GMNA is 6% larger unit sales, and GM China lacks the gold mine of full-sized pickups. But given GM's 50% share, GM's joint ventures in China earned $2.8 billion while North America pulled in $2.2 billion. China makes money.
VW's numbers paint a similar picture. The increased equity valuation of VW's China operations came to €3.5 billion in the first 3 quarters of 2013; total profits were €8.8 billion. China thus accounted for 40% of the total, on 32% of global volume. Of course at present Europe weighs down VW's profits. Nevertheless given its 50% stake, its joint venture partners in China earned €7.0 billion. Its operations are older than those of GM, so it will have lower depreciation charges; its Santana plant in Shanghai, which contained used equipment, is likely fully amortized. Its Audi brand is also the dominant luxury vehicle in China. Still, at roughly US$9 billion it substantially out-earned GM. The bottom line again is that China makes money.
So perhaps we will move towards a bipolar world, in which North America and China come to dominate global automotive profits. As the industry is currently structured, though, China's geography will remain an impediment.
Thanks to David Wiest for discussing equity accounting with me.
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