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Sunday, September 17, 2017

Autos can't live without China

mike smitka

I take part in an online discussion forum on Japan that occasionally strays into economics and business topics. One ongoing thread is the potential impact of erecting a "bamboo curtain" around China. A couple posts assert that realigning global production following the elimination of trade with China would not be a big deal. They seem to forget the havoc caused by 3/11 (the Japanese tsunami/earthquake), where damage to a mere two plants impeded global automotive production. One produced a dye essential for certain black/red paints. Red isn't all that popular in most markets, but surely the firms that used it for black lost sales to rival manufacturers who had a different pigment mix. [You don't substitute a different pigment without lots of testing – it's finicky, and the pigment layer may be only 19 microns deep. A different particle size or stickiness and you get paint that looks bad or worse, doesn't adhere. BMW owners won't tolerate peeling paint!] Then there was the Renasas plant in Sendai, which was already in the process of shutting down. Work on their new plant in Southeast Asia was accelerated, and round-the-clock teams worked as well to restart production in Japan. Fortunately there were pretty big inventories and the processor involved was used in more than one function. It did mean certain option packages weren't available, but by so China however would not be just two plants.

...without a global market, it would make much less sense for European, Japanese and Chinese suppliers to set up shop in Detroit...

The quick mistake is looking at the name on the front of the building, and assuming that what could be done by a company in one place could readily and quickly be done by the same company elsewhere. Foxconn, which assembles a big slice of the world's cell phones in Shenzhen in Southern China may for example be a Taiwanese firm, but local operations are very much Chinese. Foxconn does have factories in many parts of the world, but they are not making the same things. Ditto Corning (cell phone glass) and so on. Take down China, you take down everything.

To dig deeper, I provide two examples. One is of cell phones. The other is an extended discussion of the role of China in the global automotive industry. As what I have below is already long for a blog post, and quite frankly it's time to get back to class preparation, I don't provide any numbers for automotive trade. You can find more data and more detail in the China chapter of my recent book, Smitka & Warrian, The Global Auto Industry: Technology and Dynamics, up on Amazon on January 1st. See the link at the top of the right-hand column: as an eBook it's a mere $9.99.

In the case of cell phone production, there’s no place in the US where you could hire 50,000 workers in short order, much less the 100,000+ that Foxconn employs in Shenzhen. We do not have a thousand-plus experienced production engineers and foremen and quality managers and logistics experts and purchasing managers who could be dropped into one place. No other country does, either. We do not have firms that can supply, modify and repair the specialized capital equipment. There are components made only in China, and others that flit back and forth across borders – chip/sensor packaging isn’t necessarily in the same country as either the “fab” or the circuit board assembler. Of course there are also many management systems involved, including how to keep Samsung and Apple from seeing or even hearing rumors about each other’s prototypes. It’s Foxconn that knows how to tweak Apple’s design for volume production, and that has the "creative destruction" (= prototype testing) facilities. It’s not just a bunch of low-skill workers.

That’s even more true of the 山寨机 guerilla cell phone industry. The market for niche cell phones involves a network of small companies and finance specialists, where one company can come up with an idea for a phone. An example is putting two SIM cards in a phone instead of one, not a big deal in the US, but it's important in many countries where different carriers have different service areas, and for people who cross borders frequently. So in the background it's necessary to have close ties to wholesalers who ask for something of that sort. A design house can handle the case, specialist firms tweak the circuitry, others do the software patches, other source the parts and components, and finally a job shop assembles the phones. Of course there’s finance involved, lending to such firms – except for the assembler, none may have as much as a dozen employees – is again on the basis of relational capital. It took years for this network to evolve. Pull out a piece and you have nothing. Now that’s a China-based industry, but it should convey the level of sophistication on the China end of things.

For the automotive case, the posts on the NBR Forum included lists of several global components manufacturers, with the implicit assumption that they had cookie-cutter plants in several locations. Sometimes that's the case, though if China is a big piece of the global automotive pie, there may not be enough capacity. Such plants, though, are no longer the core of what's done in China. Three different strategies governed the entrance of global suppliers into China. Let's work through them.

First, some were “simple” branch plants, which suppliers started building in numbers in the late 1990s, such as for wire harnesses or aftermarket parts or other relatively unsophisticated components. (Caution: what was unsophisticated in 1990 may be a high-tech part today!) This business strategy sought to save on labor costs and export all production. For such technologies there are often only modest economies of scale, and plants are scattered in a number of countries. For wire harnesses more are in the Philippines than China, but some production remains in Mexico. (None in the US, except for low-volume high-voltage harnesses and small-lot production for pre-production vehicles.) Assuming a location with an adequate labor force could be located – such plants quite often employ thousands, and need a hundred or more supervisors and assorted other skilled managers – production could be shifted in a few months. But in the interim automotive production would drop to zero, and for some time quality would remain low. But hey, who needs windows that roll up and not just down, or a transmission that shifts properly?

Second, another pattern was to serve as a regional supply base, but with excess capacity for what in the early 2000s were the bigger markets of the EU and NAFTA. In one particular case with which I'm personally familiar, the capital equipment and top supervisors were from Germany, but there task was to replicate a plant in Virginia (which happened to be the company’s first location for a new high-tech component). Such production in China might not be much affected by US policy, assuming they could continue to import certain components. If there was a supply crunch, it would initially be production in Thailand, Korea and Japan that would shut down. But that would be awkward for a global supplier, so surely a portion of what remained of their global production capacity would be redirected from the US to keep them running, at the expense of producers in the US.

Now in this case there was initially no particular human capital on the Chinese end, but physically moving the equipment and then getting a plant up and running again would take 9 months to a year (that's what it took to set it up in China in the first instance). Of course depending on the legal framework – there was no legal mandate for joint ventures for automotive components, but many firms chose that route – their joint venture partner might not let them ship out the capital equipment, and the Chinese government would surely discourage such, even if you could get paperwork on the US end to permit transiting the bamboo curtain. In that case, ordering new equipment and tweaking the line to get it running would take much, much longer. My sense is that it would prove impossible to do in under 3 years, because of the backlog that would arise as everyone tried to place orders simultaneously. And it might take longer – much of the underlying tool and die capacity is now in China (both machines and skilled tradesmen). In any case, when there are only two-three global plants supplying a particular component for global gasoline engines programs, there would be massive disruption. And for things such as fuel injectors or valves or bearings, engines are designed around a particular firm’s component – no double-sourcing, so the engine would have to be modified to use a rival’s fuel injector or similar component, and then re-certified. But by and large rivals have similar footprints in China, so there’d be no workaround in going to another European/American/Japanese firm.

The third pattern is now the most important. China is the world’s biggest auto market (25 million units of light vehicles, more than either the EU or NAFTA). Many models launch first in China or are variations specific to China, and 40% of sales inside China are of vehicles engineered and assembled by domestic Chinese firms, not “global cars” from VW, GM (the two biggest car firms in China) and other foreign auto companies. To serve these customers, Chinese and otherwise, global suppliers have significant operations in China. Three very large global suppliers ($8-$20 billion sales) I’ve visited recently now have major engineering centers in Shanghai that are part of their core global R&D operations. Over the past decade all three have shifted towards local specialization. As very large firms, each has a dozen-plus R&D centers, located in at least a half-dozen countries. At one time they'd each do a little bit of lots of things. Now each center focuses on a specific component or technology as a "global center of excellence". As a reflection of that strategy, R&D in Shanghai is integral to global operations. Indeed, one of these firms (quietly) moved divisional HQ operations there, too, planned over a number of years to coincide with the retirement of several key people in the home country. First the senior person worked in Shanghai for a couple years, and then his designated Chinese successor worked at divisional HQ in the home country for a couple years, with others less senior moving back and forth for shorter stays (6 months or more) over a period of years. To repeat, it took years to set up a new R&D center, to build a team who could work with each other and with the rest of the global enterprise.

One driver for this particular firm was the ability to hire engineers in China. Another, though, was that China was the division’s largest and most profitable market. Indeed, today GM’s main engineering center in Asia is at PATAC in Shanghai, with over 2000 engineers and 15-plus years effort at building up teams (subcompacts continued to be done by Daewoo in Korea, but more and more of the next larger platform is done in China, not just the "top hat"). With GM’s sale of their European operations (Opel/Vauxhall) to PSA, Shanghai is now central to GM’s ability to design vehicles (again, platforms, and not just “top hats” for the Chinese market). To my knowledge other firms (eg, VW) are less China-heavy in their engineering, particularly the Japanese and Korean firms, but all have major operations there.

In sum, the auto industry is today tightly integrated on a global basis. You can’t pull out one piece from any of the 3 major centers (NAFTA, EU, China/Japan/Korea), and major suppliers typically have additional pieces of their global R&D footprint in Southeast Asia, India and Brazil. Factories are not mobile, engineering centers less so. Building a bamboo curtain between the US and China would shut down the US industry, and not just for months. It would be particularly ironic in that a couple initial studies suggest that the role of Detroit as a global engineering center is increasing – it’s no longer just a regional NAFTA role. That includes Chinese suppliers locating R&D centers in Michigan (I’ve visited one). Of course I’ve also visited factories in the US that ship a significant part of their output to China. Without a global market, it would make much less sense for European, Japanese and Chinese suppliers to set up shop in Detroit.

But it would be a huge hit to many industries, not just autos. It wouldn’t make America great again, and if the impetus came from the Washington, it would lead global firms to not put anything of value in the US.