There were reports in China earlier this week that a residential property developer was throwing in free BMWs for those who signed up for slow selling units at a luxury apartment complex in Wenzhou, where property prices have fallen sharply in recent months.

Change is in the air. It may not be visibly obvious, with plenty of evidence of new construction activity in cities across the country and many streets still clogged with new cars, but China’s phenomenal growth is showing distinct signs of an easing. It’s in part a consequence of domestic issues – especially the official response to a speculative boom to asset prices – and in part due to slowing exports (if the developed world is depressed, China isn’t fully immune). The big question is: how severe will this slowing turn out to be and what will be the impact on China’s high-growth ‘sunrise’ industries – such as automotive?  

Beijing has been seeking to prevent overheating in the Chinese economy for some time now. Since October 2010, interest rates have been raised five times and the government has increased banks’ reserve requirements nine times, in an effort to cool frenetic activity and dampen inflationary pressures. There have also been specific measures aimed at curbing soaring asset prices, especially in the property sector. It would seem that the property price bubble has, indeed, been punctured. But it requires a deft touch to avoid overdoing the cooling, something that could yield a hard rather than soft landing for the Chinese economy.

It is also important to understand that construction activity has been at the heart of China’s economic boom and the steady growth of domestic demand and real incomes in recent years. China still exports plenty of manufactured goods to the world, but it now has plenty of demand at home, too. The worry though, is that if that construction tap is suddenly turned down too sharply, the adverse effects could ripple through the whole economy and bring an overly sharp correction to GDP growth, which is now dipping significantly below an annual rate of 10% (China’s economy grew by 9.1% in the three months to the end of September, down from 9.5% in the previous three months).

How is the auto industry faring amid talk of a cooling down for the Chinese economy? After two years of unprecedented expansion (vehicle sales up 33% up in 2010 to 18m), China’s vehicle market is clearly returning to a more subdued growth pattern. The cooling has been attributed to the termination of government tax incentives and local government initiatives aimed at easing ever-worsening traffic congestion. This, some observers say, is expected to hit local car makers more than overseas players which have superior fuel-saving technologies.

There are also signs of discounting in the market as automakers increasingly struggle to hit volume growth targets. This year output has been much higher than the wholesale sales for several months, forcing OEMs reduce prices to have a hope of hitting sales targets – but they tend to go for the targets and sacrifice margins, at least to start with. BYD is a good example. It posted an 85.5% decline in net profit through the first nine months of 2011. Like many others, it missed its volume targets in any case.

Growth of demand in China is now expected to come from solid demand in tier 2 and tier 3 cities (tier 1 places nearing a phase of ‘initial’ market saturation), further capacity expansion and hopes that a slowing Chinese economy will eventually bring an easing monetary and fiscal policy stance (Beijing is wary of the need to maintain growth and avoid any social unrest that could come with higher unemployment). But those sales in the ‘inland’ cities will likely be harder to get than the ones that the industry has been enjoying over the past few years. Further out, replacement purchases in the tier 1 cities could come into play to support new car sales, but the dynamics of that remain uncertain (like how the used car market will evolve).

The latest market numbers certainly appear to illustrate a market topping out. In October,  year-on-year vehicle sales in China dropped 1.1% from a year earlier to 1.52m. This year saw the cancellation of the preferential sales tax on small displacement vehicles that saw tax reduced to 5% from 10% in 2009, then increased again to 7.5% in 2010 and then returning to the original 10% for 2011.

The China Association of Automobile Manufacturers (CAAM ) now expects China’s overall auto market to grow less than 5% this year. In the summer it was looking for 10-15%.

But despite the slowdown in demand growth, domestic carmakers are still actively increasing their production capacity. It’s a long list. FAW-Volkswagen’s third plant has started operations in Chengdu. Shanghai-GM has laid the cornerstone for a project that will increase its annual production capacity by 300,000 vehicles. The Changan PSA Automobile Company in Shenzhen has received government approval, and is expected to manufacture 500,000 vehicles a year. DPCA has started construction on its third plant in Wuhan, which will lift the automaker’s annual production capacity to 750,000 vehicles by 2015. Beijing Hyundai’s third factory is expected to commence production in early 2012 and will produce 400,000 vehicles annually, enabling the joint venture to become the fourth with capacity to roll out over 1m vehicles annually. Changan Ford Mazda Automobile and Jiangling Motors Company are also building new plants. And KIA has just announced a third plant for China which will boost its annual capacity there to 730,000 units (and a fourth plant is under consideration).

China’s National Development and Reform Commission projects that the total annual output of China’s 30 major carmakers will reach a staggering 31.2m vehicles by 2015.

Chen Bin, director of the Industry Coordination Department of the National Development and Reform Commission, was reported in The People’s Daily as saying that serious overproduction will lead to a series of issues, such as ‘cut-throat competition in the auto market, a decline in the profits of auto enterprises and the idleness of production capacity’.

Local observers also note that there is a strong political driver behind capacity growth in China because of the regional way that the industry is structured. Local government is encouraging expansion of auto industry capacity to advance the local economies. The automotive industry has long been seen in China as a ‘pillar’ industry with a long supply chain; it has a resonance with politicians and technocrats that gives it a big role in local economic development plans – and these are plans that display little reconciliation to any national strategy for the industry. When it comes to a national strategy for the automotive sector, Beijing’s influence has been minimal, for example in wanting to encourage consolidation for healthier scale economies. The highly vertically integrated automotive groups with their local power bases are just too strong.

The demand boom of the last few years has generally kept automotive enterprises fully employed and diverted attention from these structural issues. Adding capacity was seen as ‘the norm’ in order to meet inexorably rising orders. Do that or miss out on sales was how it was seen. The strong urge to expand auto production capacity is a consequence of the recent market boom. However, it looks like we are about to enter a period where capacity runs ahead of the market.

“Its no secret that car manufacturers in China are rushing to build more factories, but they seem to be ignoring signs of slowing in the market,” says Ash Sutcliffe of Qingdao-based website China Car Times. “Either manufacturers are ignoring the data to hand, or they know something that we don’t.” To which could be added, they each tend to assume that their rivals will be the ones who suffer in a softer market. It’s a problem for others and ‘we have the best proposition, best models and best business set-up to appeal to consumers and make best profits’. No sales and marketing manager worth his salt says anything else, but China’s phenomenal market growth in recent years has probably given such hyperbole greater currency.

There is also a rush by the big joint ventures to add new local brands, something that they have come under a lot of political pressure to do as part of the government’s localisation push. That will add further to the supply wave with cheaper cars becoming increasingly available in China. Sutcliffe also detects moves to further shave cost. “Interestingly, some of the international manufacturers are moving to further localise by introducing engine and gearbox plants into the Chinese market to diversify their line up with new technology and of course lower prices,” he says.

China’s annual inflation rate fell to 5.5% in October from September’s 6.1%, a sign that Beijing’s economic policies are working. Auto industry participants will be hoping that that is indeed the case and that vehicle demand growth in China will resume, any hiatus kept to a minimum. But even if that is the case, China’s domestic vehicle market environment appears to be entering a more challenging phase. It may cause some international vehicle makers to look a little more closely at their China capacity expansion plans, their JV operations and how they fit into global sourcing strategies.