Mike Smitka, economics / Washington and Lee
First to exit, that is. The rush to enter China has led to a market with too many players with too many products and too many assembly plants that are too scattered in geography. The logic is reminiscent of the dot.com era, a combination of optimism unbounded by reality tinged with a belief that, in a market where most consumers are first-time purchasers, buying "clicks" today is essential for future profits. (It's also a predictable consequence of China's policies toward the industry, a topic for other posts.) Most of the new entry and the additions to capacity over the past 10 years took the form of a 50:50 joint venture between a Chinese automotive firm and a global producer. It takes two to tango, and "domestic" players were just as eager to dance as latecomers. But 10% GDP growth and 20% industry volume growth weren't going to continue forever.
...after excess entry, the question is who's first to go?...
Well, the future has arrived. Over the past 15 years, with the 2001 launch of the Buick Sail as a turning point, profits have been shrinking. But they were still high – some analysts claimed that 60% of VW's profits were from its various ventures in China, reflecting a combination of still-fat margins and robust volume. Those heady days are now a thing of the past. While the two market leaders, VW and GM, are hardly likely to go away, not everyone can be in the lead.
Now 50:50 joint ventures are intrinsically unstable. In reality contributions to the venture by the two sides aren't going to be equal; these aren't the sort of startups where the two sides provide little more than cash. Interests diverge. When the Chinese partner is tied to local government, the goals are employment and local tax generation rather than profits, which lack political salience. In addition, the contribution to date was handling local hiring and permits, providing land, and putting in the word at the local branches of banks. The foreign partners contributed knowhow (with varying levels of expat staffing), production rights and kits of imported parts to speed launch. They may have also borrowed under their own name to fund construction, while reinvesting rather than repatriating profits. Other joint ventures are with regional (provincial) governments and "national" State Owned Enterprises, with their own priorities and constraints. In any case – in all cases! – the goals of the partners do not coincide.
Foreign partners are currently limited (at least on paper) to a maximum 50% stake. Their de facto voice has been greater, as they not only pocket 50% of profits but also license fees and the margins on imported parts. (Local partners extract income before profits, too – all know the game. But for them part of the payback has included high-wage jobs and board seats.) Back to the paragraph lede "now": now license fees will be competed away, parts imports are turning into local content [global suppliers have been in China longer than many of their customers], and the foreign partners will be asked to contribute cash. And neither side may have cash, particularly once the joint venture begins burning through it with no end in sight. (Volkswagen and Honda have already cut their investment plans.)
Something will have to give. One is that the 50% ownership stake will be lifted, and global auto firms will be permitted to increase their stake. That option can be exercised only once, and won't remove the problem of negative cash flow. But I wouldn't be surprised if this shows up as part of one or another set of market liberalization measures, bundled into a package of measures that support capital flows and yuan globalization, as the fate of a few joint ventures matters less to Beijing than steps that highlight their ascendance to the global power stage.
Another outcome will be ventures that get shuttered. This has precedent: two of the first three Chinese automotive joint ventures collapsed in the 1990s. The tale of Beijing Jeep, for example, is well and entertainingly told. (I've used American Wheels as a book in my China's Modern Economy class.) This will be an embarrassment to management overseas but may be spun into "willing to make hard choices" by up-and-coming government officials in China. For them the precedents are even deeper: at one time there were 120 vehicle assemblers in China, and cumulative exits likely total about 100 (in the 2000s new entry continued even as firms exited, and there continues to be new entry in the battery electric vehicle segment and of niche producers such as Borgward.
Who will "win" will be determined in part by the strength of dealership networks. Sales are dominated by a new model effect, as they garner the attention of consumers looking for what is still their first car. Consistent with that, dealership profits stem from new car sales, evidenced by BMW's agreement to pay US$820 million and FAW-Toyota to pay US$200 million to improve the profitability of their dealers, with reports that Mercedes and Audi have done likewise. So as the share of repeat purchases (and used car purchases) rises, and as the "park" ages and repairs rise, while the share of vehicles purchased using credit approaches 50%, firms with networks that encourage brand loyalty and can capitalize on service, F&I and used car sales will do better. Those whose dealers opportunistically entered the market while new car profits were high will have a hard time keeping a presence in smaller cities. (China has 200+ cities with populations over 1 million.)
Due to the structure of dealers in their home markets, my hunch is that GM and Ford will do best, witness the rebates already paid by German and Japanese firms. Meanwhile, luck remains a component. Great Wall and Changan, for example, happened to be in the right place at the right time with crossovers, while among joint ventures Ford and GM Wuling are well positioned. (Now everyone is launching vehicles in those segments.) But domestic brands face what Lauren Brandt and Eric Thun label the "battle for the middle" as their start was as producers of low-price vehicles that perforce earn low absolute unit profits and face pressure from the bottom as the used car market develops and from the top as JVs move from down-market from their initial high-end models.
...who wins will be determined by the strength of dealership networks...
Finally, joint ventures that for the first time have excess capacity and produce vehicles up to global content and quality standards are potential exporters. These include Volvo – which is owned by a Chinese firm but functions like a joint venture – Honda and GM. (Exports by purely domestic Chinese exports have flopped; see a CAAM note.) Such exports won't be enough to drive the overall economy, unlike the vision that Chinese policymakers held for the industry in the 1980s and 1990s. At the plant and product level, however, exports can add sufficient incremental volume to put individual operations solidly into the black.
So we will see the past reappearing in 2016, with a few new twists. After excess entry, the question is who's first to go. The last to enter make good candidates.
China surely has too many firms, brands and models. The shakeout will be brutal.
- Brandt, Loren, and Eric Thun (2010). "The Fight for the Middle: Upgrading, Competition, and Industrial Development in China." Working Paper. University of Toronto, Department of Economics.