Twenty years ago, Volkswagen became the first foreign auto maker to set up a joint venture in China, and this early move seemed to give it an unassailable advantage in the market, writes Mark Bursa.

But it's not turned out that way. Last year, the wheels came off the wagon - so much so that VW is in serious danger of losing market leadership in China - a position that seemed unthinkable not very long ago.

The numbers don't make pretty reading. From a late-'80s peak market share of 90%, VW has declined steadily as rivals entered the market. As recently as 2001, VW still maintained a share of more than 50% of the Chinese market. The Santana sedan, an obsolete design based on a 1980s-vintage Passat, was the car of choice for Government officials and taxis - the main car buyers in China before sales started to boom in 2002.

Since then, VW's market share has been in freefall. Share slipped to 40% in 2002 and 32% in 2004. Last year it tumbled to a mere 17% - still the leader, but only just ahead of a resurgent General Motors, rising Japanese OEMs and a dynamic Hyundai. Both VW's China JVs are failing. SAIC-VW's sales fell nearly 50%; FAW-VW's fell more than 30%.

And it's hit VW's figures too. The company reported that its joint ventures in China posted an operating loss of EUR119 million in 2005, compared to a profit of EUR222 million a year earlier. VW has been flat-footed in China, and despite maintaining sales volumes of 500,000 units in China, the company has been outsmarted by just about all its rivals.

Of course, it was unrealistic for a single automaker to remain dominant in a market saturated by overseas investment. The Japanese and Koreans are newcomers in China, but with their Asian styling and sensibility, they were bound to make serious gains.

But as well as strong new rivals from foreign JVs, China has also seen the rapid growth of independent automakers such as Chery and Geely, whose cheap, all-Chinese efforts have found favour in the market for reasons of patriotism and economics.

Sitting fat, dumb and happy at the top of the sales ladder, VW was easy prey to these rivals. Its JV with Shanghai Automotive still churns out the old Santana - the car it started with in 1985. The car has been updated to look like a more modern Passat, but it's still built in a way that is far less efficient than the newer JVs.

VW's other JV, with First Automobile Works, makes Golf-platform models as well as Audis. It's newer than the SAIC-VW venture, and from VW's position, the two ventures have a good strategic fit - SAIC in the south, FAW at Changchun in the north. But in practice, there's very little synergy. VW has fallen foul of the intense rivalry between FAW and SAIC - so there's no common distribution channel. And no common suppliers, so manufacturing economies of scale are limited.

This wouldn't matter so much if Volkswagen made the right cars. The Santana just won't do any more. A revised version, the Santana 4000, is being rushed to market by 2007, but it's unlikely to revive sales. China is an increasingly sophisticated market - and car buyers don't want cars based on old, hand-me-down technology. The hot large cars in China are current global models such as the Hyundai Sonata or Honda Accord.

The real, explosive growth in China is from the small car sector. This is where Chery, Geely and the other fast-rising Chinese automakers are gaining ground. It's a price-sensitive sector - and it's one VW simply isn't equipped to play in. An attempt to launch the Polo in China has met with failure - in the first half of 2005 only 4,000 Polos were sold, compared to 54,000 Chery QQs.

Volkswagen chief executive Bernd Pischetsrieder said the decision to launch the Polo in China was wrong because the model was too small for the market. Not so. Polo doesn't sell because it's too expensive. Not only does VW not have the right cars for China - its boss doesn't know what the right cars are.

How can VW stem the collapse? It's not clear whether it has the technology. Skoda, supposedly a low-cost producer, effectively builds rebodied VWs using lower-cost labour. It doesn't have the inherent low-cost technology that GM gained through its shrewd acquisition of Daewoo. Skoda has nothing in its line-up like the Chevrolet Matiz or Aveo small cars - on which much of GM's growth is based. Nevertheless, Skoda will be launched in China - VW has said it will bring 10-12 new group products to the market by 2010.

Perhaps the best hope lies in VW's Brazilian operation, which has just launched a genuine low-cost car, The A-sector Fox, which VW is launching worldwide as an entry model. An earlier Brazilian VW, the Gol, was launched in China, but sales were so poor that imports have now ceased. But Fox offers an option - probably the best in VW's locker.

Volkswagen is slashing costs everywhere - it wants to save the best part of $5bn a year by 2008 - and there could be some benefit here, in that China parts procurement is likely to be raised. Purchasing director Francisco Javier Garcia Sanz recently said: "In the next three years we want to have purchasing volumes of $1bn from China," around four times current levels.

And more China-built VWs could be exported - some Polos are being shipped to Australia, and providing quality levels can be maintained, VW could follow Honda's lead and export from China to Europe.

But for long-term success in China, VW had better learn how to make small cars cheaply - and that expertise might have to be outsourced, or bought in. There are a couple of bright, young independent companies in China that already have that know-how, and might even be prepared to share it - for a price…

Mark Bursa