After an explosive couple of years, China's car market hit the buffers in 2004. The Chinese Government effectively put the brakes on the market by clamping down on credit to prevent a rash of new bad loans from being set up. As a result, the doubling of sales that was experienced in 2003 slowed down dramatically in the second half of the year. Mark Bursa reports.

Year-on-year increases in car sales slowed dramatically from 21% in May to 4.8% in June and 3.7% in July as credit controls kicked in. While this measure has dampened the explosive growth of 2003, when car sales almost doubled to just under 2m units, it has not killed the market off. Far from it - car sales started recovering in August, up 7.4% year-on-year to 170,300 units, as waves of price cuts made cars ever more affordable to Chinese consumers. Even a 20% rise in the Chinese market is vastly better than the stagnant Western European and North American markets.

Despite the slowdown in sales, there has been no let-up in the pace of investment in the market, with all the leading automakers jostling for position in the market. Carmakers are talking big numbers - altogether, foreign automakers are spending US$13bn to triple annual capacity to 6m units by the end of the decade. But this has raised new fears that overcapacity, the bugbear of the auto industry in its developed markets, could hit China as well.

Overcapacity would lead to a hotting-up of the price war that is already raging in China, analysts fear: "The price wars are set to rage for at least the next two to three years. Nobody is going to be immune," said Lin Wenjun, auto analyst at Capital International Holdings in Shanghai. Haitong Securities analyst Gu Qing said: "The market is becoming saturated. We are just not going to return to the heady days of growth." And JP Morgan analyst Frank Li added: "China's auto market will face increasing oversupply in the next two years." JP Morgan estimates oversupply in China to reach 11% this year and 23% in 2005.

Already many automakers have slashed prices in 2004 in a bid to shift inventories. Many have also reported drops in profits - Ford's main Chinese partner Chang'an Auto posted a 7.3% fall in second-quarter earnings, despite a 27% increase in sales in the first half of the year and a 40% increase in turnover in the same period.

Share prices of listed Chinese automakers tumbled on the Hong Kong stock exchange. In the first nine months of the year, the share price of BMW's partner Brilliance China fell 60%, while Denway Motors, a joint venture partner of Honda Motor, dropped 28%; Great Wall Holdings fell 56% and Qingling Motors 35%.

Clampdown on loans
Last year loans accounted for some 20% of purchases, but in 2004 credit curbs have limited the number of cars bought on borrowed money to 5-10% of the total. The new rules, were "aimed at regulating the vehicle loan business to prevent risks and safeguarding the legitimate rights of lenders and borrowers", according to the Central Bank. The rules covered vehicle loans extended by commercial banks, urban credit cooperatives and non-bank vehicle finance firms. China has no central credit rating agency, no laws to repossess cars from errant borrowers and a rising level of bad car loans - up to one in 20 loans ends in default.

Under the rules, most vehicle loans have a maximum five-year maturity with interest rates determined on the basis of the interest rate policy of the People's Bank of China. Lenders must establish sound credit ratings on borrowers, including assessing their jobs, incomes, guarantors and payment histories to help prevent risks, the report added.

Banks and other lenders would be allowed to make loans to car dealers, but they must establish credit rating systems on them, while the amount of the loan to ordinary car buyers cannot exceed 80% of the price. The credit ceiling for buyers of commercial vehicles would be 70% and banks must keep tracking vehicle loan borrowers and make adequate provisions for bad loans.

"The credit curbs did have huge negative impact on car sales," said Yale Zhang of auto consultancy CSM in Shanghai. "Now we have to adjust our forecast of 2.6-2.8m units to about 2.4m units for this year." Sales to the end of August had reached 1.5m cars, up 23.68% from a year earlier, according to official China Association of Automobile Manufacturers data.

Despite the short-term effect of the new rules, the long-term trend will be for a massive increase in the percentage of cars sold on finance. This is because China has granted approval to a number of automakers - including major players General Motors, Volkswagen, Ford, PSA, Toyota and BMW - to set up in-house or joint-venture finance schemes.

VW Financial Services chairman Burkhard Breiing said he expected the number of cars financed in China to grow to about 40 to 50% of cars sold per year by 2010, compared to 10% now. He said the venture had start-up capital of US$60m and was expected to break even in five years, though he did not expect an immediate return because of the lack of consumer credit data and high default rates.

Christian Weidemann, general manager of GM-financed US$60m joint venture between the finance unit of long-time Chinese partner Shanghai Automotive Industry Corp, said it takes 10-15 minutes to approve a car loan in the west, but up to ten days in China. Bankers even physically check on borrowers at their workplaces to verify their identity. "We don't want to be trapped like other banks and be faced with losses. Doing a proper job takes some time," he said.

Price wars raging
Across-the-board price cuts averaging between 10% and 15% have been made by most Chinese automakers this year as they attempt to clear inventories and stimulate the slowing market. This is in line with price cuts in 2003, according to analysts.

Even up-market cars are not immune from price cuts - in October Audi cut the price of its China-made models by up to 15%, blaming a weak auto market and increasing competition, notably from locally assembled BMWs. The new lower prices represent the first such large-scale reduction in China's luxury auto market, Audi said. Audi has a joint venture with China FAW Group in Changchun.

Impending cuts in tariffs and the proposed removal of import quotas have also prompted price reductions: GM cited these changes as the reason for an 11% reduction in prices in April of two core Buick models in China. GM's main rival, Volkswagen, followed GM's lead by making price cuts of up to 11.7% from May. "If Volkswagen wants to maintain its commanding position, it has to follow GM's lead," said auto analyst Zhao Lei at Orient Securities. "It's also a move to cut inventories in light of the slowing car market."

Shanghai Volkswagen, the German company's venture with Shanghai Automotive, trimmed prices on 30 models such as the Santana and Polo. The heaviest cut of 11.7% was for the Gol, which now sells for around US$9,000. Other automakers have had no option but to follow suit. Beijing Hyundai Automobile, a 50:50 joint venture between Beijing Automotive Industry Corporation (BAIC) and Hyundai Motor, has cut prices on nearly all its models by an average of 10% in September.

Analysts believe established carmakers are unlikely to be badly affected by sliding prices initially, due to their strong brands, but they warn that lower-end producers such as Geely could be hit hard. Geely, which is unaffiliated to any major western or oriental OEM, reported that vehicle sales at its retailers fell 32% in August as dealers were reluctant to replenish inventories, hoping instead for factory-gate price cuts on old models prior to the launch of new models towards the end of the year.

This strategy worked well for Brilliance China, which reported that sales of minivans rose 80% to 5,400 units in August compared to July after it cut prices of old models by 10% to 12% and launched cheaper models.

This feature has been extracted from a just-auto management briefing published in November 2004. The full management briefing is available exclusively to just-auto members here.