A few seasons ago, America's National Football League adopted a new policy - I call it the red flag rule - that allows teams to protest calls made by officials on the field, writes Michael J. Dunne. When a team does not like what it sees, the head coach tosses a red flag out onto the field, time is called, and officials trot over to the sidelines to view taped replays of the action.

After some minutes, the head official makes his decision about the play in question - either to stick to the original call or overturn it. He gallops back onto the field and informs everyone in the stadium of his final verdict. One team typically cheers the decision while the other grumbles. Things settle down and play resumes.

More and more, the NFL's red flag rituals reflect the nature of competition in China's automotive industry. Global automakers, their local partners, and Chinese companies all square off in the quest for victory. Each wants to build more cars and capture more customers. From time to time, something unexpected happens. Companies respond by raising the red flag: they appeal to the Chinese government for a ruling.

It is at this point that things in China start to get really interesting. Just as the referees in American football see different pictures depending on the angle of the camera, so city, provincial and central governments interpret and rule on events differently from one another. What the authorities see depends on their point of view and, of course, on their vested interests.

It is this ambiguity in the legal sphere that leads some to offer an exaggerated interpretation of how things work in China: "There are really no rules. You just do something first, then find someone powerful in government to agree with you."

As China gets comfortable with its perch as the world's third-largest vehicle market, reviews and rulings are taking on unprecedented importance. At stake today are hundreds of millions of dollars in investments and tens of thousands of jobs. In this environment of lofty financial and political stakes, you want to do everything in your power to persuade the judges to rule in your favor.

But who can predict the judge's final verdict?

Bluestar's Surprise
On December 23 2003, executives from China's Bluestar Ltd. arrived in Seoul, Korea, for a festive signing ceremony to mark the acquisition of Ssangyong Motors. A day earlier, Korean creditors and regulators had announced that Bluestar had outbid five other automakers for the rights to acquire Ssangyong, the troubled maker of sedans and sport utility vehicles, for US$ 600 million.

News of the acquisition puzzled and surprised analysts. First, no one in the auto industry had ever heard of Bluestar, a Chinese state enterprise that had made its fortune cleaning nuclear power plants and running a fast-food noodle chain. Second, the offer of US$ 600 million was more than twice the amount that General Motors had paid for Daewoo Motors, a much larger concern, in 2002. And third, China tightly controlled overseas acquisitions by state enterprises. Bluestar's winning bid was hard to fathom.

When asked at the signing ceremony whether officials in the Chinese central government had given their blessing to the deal, the spokesman for Bluestar shot back, "Of course we have permission." Active buying of the Ssangyong stock pushed the value of the shares up 70 percent.

But the next day, when a reporter asked Bluestar to identify which agency in Beijing had given permission for the deal to go through, the spokesman was more circumspect. "Well, no one has said that we do not have the authority." Two days later, the State Development and Reform Commission, a powerful agency that reports directly to China's State Council, declared that the Shanghai Automotive Industry Corporation had sole authority to bid on Ssangyong. There was no mention of Bluestar. Today, the situation remains unresolved, awaiting a final ruling.

One might think this sort of confusion happens only among Chinese companies: not so. Ambiguity and surprises are surfacing with greater frequency, with European, Japanese and American companies often finding themselves in the center of the action.

One Monopoly For You - Sort Of
In 1996, General Motors outbid rival Ford to become the foreign partner for China's highly-prized "luxury car" program. With assurances from the central government that GM would enjoy a monopoly in the luxury car segment, the world's largest auto maker proceeded to build a US$ 1.7 billion plant in Shanghai to produce Buick sedans. Beijing anointed the Buick Century the exclusive product in its size category and price point (around RMB 300,000). Shanghai GM was to have unfettered access to Chinese mid-luxury car buyers, and no direct competition.

But less than two years later, Beijing abruptly gave Honda and its partner, the Guangzhou Auto Industry Corporation, approval to manufacture and market the Accord sedan, a direct competitor to the Regal. And the entry cost was a fraction of what General Motors paid - only US$ 250 million.

Understandably dismayed, General Motors tossed out the red flag, protesting to the governing agencies in Beijing: How could Honda get permission to make the Accord?

The response from authorities in Beijing was conciliatory but firm. Honda would be allowed to proceed with the Accord program. Analysts believed this decision was made because Guangdong Province (where Honda production was to be located) was the nation's leading exporter and earner of foreign exchange, and therefore had powerful sway in national politics. Furthermore, the explanation continued, some un-named people "high up in Beijing" wanted Honda to be part of China's auto industry. Period.

GM tasted first-hand that surprise developments on the Chinese playing field were open to interpretation. But as things developed, the market's stunning growth has diminished the controversy over the decision, as both Honda and GM have enjoyed growing business and attractive profits in China.

With a Chery on Top
Regardless of comfortable profits and growth, no company could resist throwing a big red flag at what happened next. The scene was the Shanghai Auto Show in April 2003.

SAIC-Chery, a three-year-old Chinese state enterprise, had just unveiled its new product, the Chery QQ. The fresh-looking mini car created sensational interest from prospective car buyers. But the model received even more intense inspection from General Motors. The executives at GM immediately recognized the Chery QQ was almost a carbon copy of the Matiz, a mini car developed by Daewoo. General Motors, which had acquired Daewoo in 2002, was itself preparing the China launch of an eerily similar vehicle, to be called the Spark!

Then came another shock. Chery would price the QQ at just RMB 50,000 (about US$ 6,000). GM, which had to amortize the R&D costs of developing the car, was set to launch the identical product in the fall for around US$ 8,000. In this highly price sensitive segment, what consumer would be willing to pay 33 percent more for the exact same car?

Out came the red flag. GM appealed for a full review and some answers. How had SAIC-Chery managed to secure the drawings for the vehicle from Daewoo, a company owned by General Motors? Did the Chinese government actually give the green light to this car program?

Further complicating the picture was the fact that the Shanghai Auto Industry Corporation, GM's partner in China, was also a minority shareholder in SAIC-Chery. Did SAIC have active knowledge of these developments? As of the time of this writing, some of these questions have been answered, others not.

It appears that the Shanghai Auto Industry Corporation (SAIC) has divested its 20 percent share in SAIC-Chery. GM had insisted that its partner distance itself from Chery. According to the Financial Times, SAIC divested at the end of 2003.

With regard to the issue of purloined technical drawings, however, things appear less open and shut. According to sources close to SAIC-Chery, the company made a handful of cosmetic changes to the original Daewoo Matiz product. SAIC-Chery company lawyers then registered those changes, along with the product itself, with copyright and trademark agencies in Beijing. If GM were to pursue court action against SAIC-Chery, the US automaker may find itself in a morally strong, yet legally weak position. GM is reportedly continuing its own investigation, with the aim of bringing overwhelming evidence of Chery wrongdoing to the Chinese authorities.

In the meantime, however, action on the field proceeds apace. In late 2003, Chery unveiled its newest product offering, called the Son of the Orient. Like the QQ, this sedan is a near exact replica of another Daewoo product, the Magnus. Although GM itself has no plans to produce the Magnus in China, the company looks askance at this apparent disregard for intellectual property rights.

How SAIC-Chery secured the know-how to build the Daewoo products remains a unknown. The state enterprise, owned by the city of Wuhu, Anhui Province and four other government agencies, is tight-lipped about the case. The company instead is focusing on the market, where it racked up sales of 80,000 units in 2003.

Where is the Commissioner?
In professional football, there is always the possibility that the league commissioner, in certain cases, will intervene to overrule decisions taken on the field. In this respect, the red flag rule does not represent the final, final say.

China, in a similar way, leaves disappointed or disillusioned investors the unstated hope that some more powerful government agency may come along one day to announce a more palatable decision. This possibility, however distant, keeps players in the game. So does the money. It is an open secret that automakers like Honda, GM, Volkswagen and BMW, make operating profits in China that dwarf margins earned in North America, Japan and Europe.

Local firms seem more accustomed to the ambiguity. Chinese-owned companies approach the game with pragmatism, reciting the mantra at the center of Chinese business culture: "It is easier to ask for forgiveness than to obtain permission."
Red flags will be flying.

By Michael J. Dunne

This article first appeared in the Journal of the American Chamber of Commerce in Shanghai.

Automotive Resources Asia (ARA) offers market research and business development services to companies competing in Asian car markets. Michael J. Dunne is the company's founder. (see www.auto-resources-asia.com)

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