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  1. Analysis
November 7, 2005

Challenges ahead for the Chinese automotive components industry

The explosive growth of the Chinese car market may have hit the wall in the past year or so, but nobody could doubt the long-term potential of the market. Senior executives, including General Motors’ chairman Rick Wagoner, believe the enormous pent-up demand for cars will eventually make China the world’s largest market, eclipsing even the United States, writes Mark Bursa.

The explosive growth of the Chinese car market may have hit the wall in the past year or so, but nobody could doubt the long-term potential of the market. Senior executives, including General Motors’ chairman Rick Wagoner, believe the enormous pent-up demand for cars will eventually make China the world’s largest market, eclipsing even the United States, writes Mark Bursa.

Most of the attention has focused on the vast investments made by global automakers in setting up production facilities in China. Altogether, foreign automakers have committed in excess of US$13bn to triple annual capacity to 6m units by the year 2010. GM has predicted sales could climb to between 18m and 20m by the year 2020. And while China’s membership of the World Trade Organisation will mean the market will have to open up to imports, most of that demand will be satisfied by local production.

In addition to joint ventures between overseas car producers and local manufacturers, new, local vehicle manufacturers are emerging. Companies such as Chery and Geely are developing their own cars independently of western partners. While their early attempts are blighted by accusations of piracy and intellectual property theft, these companies are on a steep learning curve, and are increasingly turning to European design consultants to provide them with original designs – a path successfully trodden by the Koreans a decade or more ago.

The downside to this huge investment in production is the likelihood that supply will outstrip demand. In other words, the Chinese market will become blighted by overcapacity. In order to overcome this, Chinese automakers are looking to export a portion of their production – initially to other emerging markets in the Middle East, Eastern Europe and Africa, but in the mid-term to Western Europe and North America.

To achieve this, Chinese automakers must address the issue of quality – an issue that encompasses far more than the activities within their own factory walls. The entire supply chain must be able to produce components that are capable of meeting stringent homologation, environmental and safety standards of developed markets if Chinese vehicles are to be exported to the world’s major markets.

Here lies the biggest issue for the Chinese automotive industry. How to ensure that the country’s sprawling and largely unregulated components industry keeps pace with the vehicle manufacturers’ aspirations and quality levels.

The influx of foreign carmakers has encouraged leading Tier 1 components manufacturers to follow them into China, setting up transplants to serve specific plants or regions where a number of automakers have clustered. But the automotive components sector is having to contend with problems of its own – accounting scandals at Delphi, financial problems at Visteon and quality problems at Bosch, to name but a few recent issues. A number of the major Tier 1s, such as Lear Corporation, have announced cutbacks and plant closures – though it is worth noting that its Chinese plants have avoided the axe. While the JVs involving the major Tier 1s are generally designed to produce components using the same methods – and hopefully to similar quality levels – as their equivalent plants in developed markets. But these plants are not the problem.

The sheer scale of the Chinese components industry means there are literally thousands of companies producing components. Often these are basic engineering workshops using crude equipment and high levels of manual labour, which in turn gives them a potential price advantage over their more sophisticated competitors.

More worryingly, the issues of IPR infringement, piracy and counterfeiting, highlighted extensively in relation to car designs, apply equally, if not more so, to car components.

Structure and history of the indigenous domestic components industry

China’s automotive industry will celebrate its 50th anniversary next year. China’s first automotive factory, First Automobile Works, started lorry production in Changchun, northern China, in 1956.

But until 1986 it was focused entirely on the production of basic, utilitarian commercial vehicles. And until 1993, China was a centrally managed, planned, Communist economy. Five-year plans along Soviet Russian lines had been implemented in 1952, and initial attempts to establish an automotive industry were based on technology transfer of trucks from the Soviet Union.

However, the breakdown of relations with the USSR in 1960 led to a change in Chinese industrial policy, devolving power to provincial authorities. This led to fragmentation of the auto industry, and hundreds of self-contained, vertically integrated commercial vehicle factories were set up around the vast country. To serve these, thousands of small engineering works grew up, producing low volumes of components in basic, crude and labour-intensive conditions.

The cultural revolution of 1966 and China’s subsequent self-imposed ten-year isolation from the world saw any influx of new technology dry up. Obsolete designs remained in production, but the industry fell behind rapidly developing neighbours such as Japan and South Korea. Not until the death of Mao Zedong in 1976 could reforms begin.

Mao’s successor Deng Xiaoping made the car industry one of the cornerstone industries for rebuilding the country. In 1980, he passed responsibility for restructuring the industry to the Ministry of Machine Building (MMB), giving it a wide brief to rationalise and modernise the industry, using foreign technology if necessary, and to instigate moves toward a market economy – a controversial decision for the time.

Until 1986, the Chinese auto industry had focused entirely on truck production. But in 1986 a shortage of foreign currency, caused partly by the import of cars, prompted a decision to shift priorities to car manufacturing. The passenger car programme authorised the setting-up of six joint ventures with foreign carmakers, and while these have shifted over the years, they have formed the cornerstone of China’s car industry.

The MMB had already recognised the need to regulate and shape the components sector: in 1982 it reinstated the China National Automotive Industry Corporation – a centralised planning organisation that had existed in the days before the cultural revolution. Then, CNAIC had organised the Soviet-style five-year plans. Now it was faced with making sense of the sprawling and unmanaged mess that had developed in the intervening 16 years.

By this stage there were around 200 vehicle manufacturers in China, and around 2,000 component makers. These produced a total of 220,000 vehicles a year, mainly obsolete truck and bus designs. The only cars produced were large sedans for government use.

But the structure was as outmoded as the vehicles produced. Components suppliers were subordinate to the manufacturers they supplied; resources, personnel, equipment and so on was allocated by the manufacturer through the central planning system. As vehicles produced were allocated to users rather than sold commercially in anything resembling a marketplace, quality was not much of an issue.

CNAIC set about starting the process of reform. One of its most significant initiatives was the creation of the China Auto Parts and Accessories Corporation (CAPAC). This was another central planning organisation, tasked, essentially, with the creation of a Chinese national components industry. CAPAC’s job was to evaluate components companies and to select those that were deemed sound enough to warrant government support. Eventually, it chose 57 companies, many of them subsidiaries of vehicle manufacturers. These companies would become the ones capable of forming joint ventures with foreign components companies, though progress remained slow.

By the early 1990s, the Government acknowledged the need to increase the pace of change. In November 1993, the Chinese Communist Party announced that a “socialist market economy” would be introduced, which passed responsibility for the industry to the businesses, with mergers and acquisitions, pricing decisions and so on to be set according to market forces.

Shortly after, in February 1994, the Chinese Government issued a crucial document – the Implementation Policy of the Motor Industry (IPMI), which set a series of key objectives for capacity and guidelines for foreign investment. Crucially, this document represented the first step in regulating and encouraging the development of a self-sufficient components industry, defining “concentration on key components” as an area of “major importance”.

As far as the components sector was concerned, IPMI was attempting to build on the work of CAPAC. Its objectives were defined at the Auto Parts Presentation, Seminar and Exhibition, held in Beijing in 1995.

The IPMI also called for the creation of three or four giant independent carmakers – the favoured companies being Shanghai Automotive Industries Corporation (SAIC), First Automotive Works (FAW) and Dongfeng Motor Corporation. Together, these three companies (the so-called Giant-Giant Enterprises) controlled 51% of the Chinese market in 2003 through a combination of joint ventures and cars produced under their own brands. A further nine Chinese firms took a combined 40% share of the Chinese market.

These companies immediately exploited the changes in the regulations and started a process of acquisition, buying up many of the small independent vehicle makers and component makers, thus creating huge, vertically integrated automotive companies.

Historical and ongoing lack of profitability

Despite strong recent growth, companies have traditionally experienced difficulty in making money from components. In China, components companies have traditionally had a weak bargaining position with automakers, and their profit margins are traditionally lower than those of local automakers – the reverse of the position in the west, largely because Chinese automakers don’t have to carry the huge marketing expenses that automakers in the developed world have to carry.

Net profit margins of 22 domestically listed components firms declined to 1.65% on average in 2004, according to official statistics, from 3.82% in 2003. By comparison, net profit margins of 24 domestically listed automakers fell to 4.16% last year from 6.39% in 2003. And many carmakers in China are sparing no effort in cutting costs to regain or maintain profits – though this is a double-edged sword for the components sector, as demands for lower prices go hand-in-hand with greater emphasis on local sourcing. So there’s more business for local suppliers – but at reduced profit.

PSA Peugeot Citroën’s joint venture with Dongfeng has stated its intention to cut costs by US$513m in 2005, by using more locally made parts, slashing inventories and improving management. And Volkswagen’s joint venture with FAW also plans to cut costs by US$240m this year.

More worrying is the trend toward smaller, cheaper cars. The Chinese auto market is recovering in terms of volume – but growth is being driven by small cars. And small cars have lower margins, so automakers will seek to make savings through keener parts pricing.

Expert Analysis

The Chinese automotive components sector
The explosive growth of the Chinese car market may have hit the wall in the past year or so, but nobody could doubt the long-term potential of the market. Senior executives, including General Motors’ chairman Rick Wagoner, believe the enormous pent-up demand for cars will eventually make China the world’s largest market, eclipsing even the United States.

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