China's auto industry prepares for more competition

Standard & Poor''s examines whether the Chinese automotive industry is facing overcapacity and thinning margins.

Almost all of the leading car manufacturers and automotive suppliers intend to expand their business in Asia, particularly in mainland China. Currently, the country's automobile industry offers sales growth rates and profitability that are significantly higher than the industry average

Nevertheless, Standard & Poor's is concerned about the supply/demand balance over the medium to long term, and believes that this market may follow the global trend of overcapacity within the next few years. In terms of profitability, it is uncertain whether original equipment manufacturers (OEMs) will ultimately be able to generate satisfactory returns on their large investments, given the highly uncertain nature of the mainland China market and increasing competition. In addition, although legally possible, it is onerous under the country's taxation system to transfer dividends out of the country

This has not been a major issue for OEMs investing in the country so far, as all cash flows generated were reinvested to enable further expansion, however, it could become increasingly important in the future. Any OEM that decides against investing in this industry might forego an important growth opportunity, thereby running the risk of falling behind its major competitors

Standard & Poor's expects OEMs to continue to pressure their key suppliers to assist them in their expansion in mainland China. Currently, locally available components are costly and of poor quality compared with global standards

Exposure to Mainland China Market

Standard & Poor's believes that the activities in mainland China will have a varying impact on the credit quality of the individual OEMs, depending on the extent of their exposure to this market (see Table 1). Standard & Poor's believes that the current market leader Volkswagen AG (VW; A/Stable/A-1) has particularly aggressive growth plans, and is likely to be most affected by adverse market developments

Growth Opportunities

At present, commercial vehicles still represent the largest share of the country's total vehicle market. Total vehicle sales in 2003 totaled 4.4 million units, up 34% on 2002. Passenger cars made up the largest single market segment with about 45% of total vehicle sales. Standard & Poor's believes that passenger cars will experience disproportionately high growth over the next few years

Company

Exposure toChina market (2002)

Units

Corporate Credit Ratings*

Heavy existing or planned exposure

Hyundai Motor Co./ Kia Motors Corp.

3% of total unit sales

Current: 100,000; By 2007: 650,000 (incl. Kia)

BB+/Positive/ -

BB+/Positive/ -

Nissan Motor Co. Ltd.

Some import activity

Current: 0; By 2010: 900,000 (passenger cars and commercial vehicles)

BBB/Stable/A-2

Volkswagen AG

10.3% of total unit sales

Current: 600,000; By 2006: 1.6 million

A/Stable/A-1

Medium existing or planned exposure

Fiat SpA

1/2% of total unit sales

Current: 70,000; By 2007: 150,000

BB-/Stable/B

General Motors Corp.

3.3% of total unit sales

Current: 380,000; By 2006: 766,000

BBB/Negative/A-2

Mitsubishi Motors Corp.

5.8% of total unit sales

Current: 120,000; By 2010: 300,000

B+/Negative/ -

Peugeot S.A.

3.0 % of total unit sales

Current: 150,000; By 2006: 300,000

A-/Positive/A-2

Toyota Motor Corp.

3.8% of unit sales (total Asia excl. Japan)

Current: 180,000; By 2010: 650,000 (incl. Daihatsu)

AAA/Negative/A-1+

Limited existing or planned activities

BMW AG

1.7% of total unit sales

BMW AG 1.7% of total unit sales Current: 0; By 2005: 30,000

- / - /A-1

DaimlerChrysler AG

4.4% of revenues total Asia)

Production capacity expansion from 80,000 to 100,000 units

BBB/Negative/A-2

Ford Motor Co.

3.3% of revenues

(total Asia-Pacific)

Current: 20,000; Future: 150,000

BBB-/Stable/A-3

Honda Motor Co. Ltd.

1.2% of total unit sales

Current: 150,000; By 2004: 290,000

A+/Stable/A-1

Renault S.A.

0

0

BBB/Stable/A-2

Suzuki Motor Corp.

N.A.

Current: 250,000; Expansion plans: 0

A-/Stable/ -

The attraction of mainland China's market to OEMs and automotive suppliers becomes obvious when viewed in terms of the global automotive industry structure. Within a mature and largely saturated industry, which offers little growth potential, mainland China seems to represent the one major exception (see Chart 2)

Currently, more than 10 million cars are privately owned in mainland China, which translates into about seven vehicles per 1,000 inhabitants. This number is expected to increase in the world's fastest-growing auto market, according to the Chinese National Bureau of Statistics

Chart 1

Chart 2

The passenger car sector grew by 76% in 2003 compared with 2002. Industry sales totaled 1.97 million units in 2003 compared with 1.12 million in 2002. This means that the country is fast developing into the fourth-largest automotive market in the world, behind the U.S., Japan, and Germany. Global Insight Inc.'s forecast suggests that mainland China will become the world's second-largest automotive market by 2013

Industry Uses Sino-Foreign Ventures to Gain Market Foothold

Mainland China's automotive industry is highly fragmented, with every major international OEM already present through imports and, increasingly, through local assembly and production plants, which are required to be owned in conjunction with local joint-venture partners. The country boasts more than 120 auto manufacturers although only the two largest companies - First Automotive Works Group (FAW) and Shanghai Automotive Industry Corp

Chart 3

(SAIC) - produce more than 500,000 units per year (including commercial vehicles). As non-Chinese companies are required to invest in mainland China through joint ventures, virtually all the local organizations are partnering with global operators. The country's most important auto manufacturers and the key foreign joint-venture alliances are illustrated in Chart 5

German auto manufacturer VW was the first to enter the market nearly 20 years ago. The company has managed to retain its leading market share since then, although its penetration rate has continued to decline. Its sales growth slowed in the third quarter of 2003, with sales up 37% from the corresponding period in 2002, but below the 52% growth achieved in the first six months of 2003. VW's growth was also slower than the market growth rate. Its dominant market share has meanwhile been cut to about one-third. Standard & Poor's recognizes VW's leading market position in this rapidly growing, but potentially volatile market, which should allow it to achieve substantial volume growth (see Chart 3). Nevertheless, a significant increase in its existing market share is likely to be difficult to achieve, given the expansion plans all major automotive manufacturers have in mainland China and the increasing pressure VW faces from new products in the middle of the market, in which it has traditionally been strongest

Through its participation in various joint ventures, General Motors Corp (GM) is well positioned to capitalize on recent rapid growth in the market, and the company has announced plans to significantly increase its production capacity in mainland China. GM's Regal and Excelle models have managed to take market share from VW's Santana, Bora, and Audi models

Peugeot has a joint venture with Dongfeng Motor Co. (Dongfeng) in mainland China, through which it sold 86,200 Citroën vehicles in the first 10 months of 2003. In 2004, it will launch a new model based on the Peugeot 307, designed specially for the mainland China market

Domestic auto manufacturers that build their own vehicles outside the above-mentioned Sino-foreign joint ventures currently represent a small portion of the overall market. However, they are expected to grow in importance and in line with their expansion of capacity and their increase in proprietary technological know-how

Production Capacity Build-Up in Top Gear

Although three-quarters of vehicles are manufactured in the three key production regions of North America, Western Europe, and Japan, other parts of the world have grown in importance over the past few years. After enormous capacity build-ups in Brazil and South Korea over the past decade, mainland China has more recently been identified by OEMs as a new key-manufacturing region, in line with the projected market growth over the next decade. Mainland China has recently overtaken South Korea and France to become the fourth largest auto manufacturer in the world

In terms of commercial vehicles, it remains the third largest producer behind the U.S. and Japan. Total vehicle production amounted to 4.4 million units in 2003

Massive capacity build-ups will result in the addition of 500,000 units by the end of 2004. Total installed production capacity will exceed eight million units by the end of the decade (see Chart 4)

VW plans to invest euro 6 billion (US$7.5 billion) over the next five years to double its manufacturing capacity to 1.6 million vehicles. VW was the first auto manufacturer to start manufacturing in mainland China, 18 years ago. According to VW, the bottleneck that led to recent losses in market share was caused by insufficient production capacity. It still retains its leading market share of about one third, followed by GM

Japanese auto manufacturer Nissan will directly invest about Chinese renminbi (RMB) 8.55 billion (US$1.03 billion) to acquire a 50% stake in the newly founded full-line car manufacturing joint venture with Dongfeng. Nissan is targeting sales of 900,000 passenger cars and commercial vehicles in mainland China by 2010

Nissan president and chief executive officer (CEO) Carlos Ghosn has said that the company is aiming to introduce five more models in the country by 2006

Ford has announced that it will expand annual output at its joint venture, Chongqing Changan Automobile Co. Ltd., to 150,000 units from 20,000. Compared with its major competitors, Ford is a relative latecomer to the market

Chart 4

To complement its growing export activities in mainland China, BMW is cautiously expanding its local presence through local production of the 3-series and 5-series in Shenyang, Northeast mainland China, with a medium-term volume of about 30,000 units

The planned growth by domestic manufacturers is particularly spectacular: with an installed production capacity of a mere 560,000 units to date, they are set to triple their capacity by the end of the decade. Geely Automotive Group (Geely), one of the large domestic manufacturers, has announced plans to increase its capacity to 600,000 units by 2008, followed by Brilliance China Automotive Holdings Ltd., which plans to reach a total capacity of 450,000 units by 2012

Recent reports suggest that there are even ambitions for 50% of sales in mainland China to come from domestic production with domestic proprietary technology by 2010

Profitability Higher Than World Average - But for How Long?

The market price of vehicles in mainland China is significantly higher than those in most other markets, although they have been falling since accession to the World Trade Organization (WTO) in 2001. The China Association of Automobile Manufacturers estimates that vehicle prices will decline to levels in line with the world market within the next six years, as a result of the nation's tariff cuts and increases in domestic auto manufacturers' economies of scale

Tariffs on vehicle imports will decrease to 25% by mid-2006, from between 38% and 43% at present, in accordance with WTO commitments. Auto parts tariffs will be cut to an average of 10% by 2006 (see Table 2). The decline of tariffs is expected to boost the growth of vehicle imports into the country, which amounted to only 60,000 cars in the first nine months of 2003

Domestic auto manufacturers generated record profits in recent years as rising incomes increased buyer interest. Recently, profitability has been significantly higher than in most other markets: domestic auto manufacturers' average operating margin is estimated to be about 30%-35%, compared with an average of 5% in developed markets

This is even more surprising in light of current obvious disadvantages on the production cost side, including higher material costs frequently lower quality components, and higher production costs than the world average due to the lack of economies of scale and overstaffing

Labor costs, however, are favorable, amounting to only 20% to 25% of the world average

As long as production efficiency does not improve significantly, Standard & Poor's believes that it will be difficult for OEMs to use mainland China as an export base to deliver vehicles to neighboring countries. This is regrettable because, if it made economic sense, it would mitigate the potential overcapacity problem

If demand falls below expectations, the result will be overcapacity, thereby increasing competitive pressure, and, ultimately, leading to declining profit margins. There is evidence that this downward spiral has already begun. Average car prices fell by about 7% in December 2003 compared with the corresponding period in 2002. The majority of auto manufacturers in mainland China, including Sino-foreign joint ventures, launched new models and cut prices to boost sales and market share in 2003. Nevertheless, inventory levels were 37.4% higher in October 2003 compared with the corresponding period in 2002. VW's profitability in mainland China declined in the third quarter of 2003, which underlines this point. On Nov. 21, 2003 VW announced a 7.5% price reduction of its Gol model

Key Auto Industry Policies in Mainland China
Import tariffs Tariff rates on vehicle imports will decrease to 25% by mid-2006, from between 38% and 43% at present, in accordance with mainland China's commitments to the World Trade Organization (WTO). Before entering the WTO the country's import tariffs were about 80%. On components, tariffs will be lowered to 10% by 2006. Price competition will increase. Lower tariff rates will allow high quality, inexpensive vehicles to flood the domestic market but should also bring down component costs.
Import quotas Under mainland China's WTO commitments, vehicle import quotas will decrease 15% each year and be completely lifted by 2005. The Ministry of Commerce said it was raising the country's import quota on auto and auto parts to US$10.49 billion for 2004. The elimination of import quotas will force mainland China's auto manufacturers to compete directly with foreign companies. However, there are many other ways to discourage imports and the government will protect its state owned car industry.
Local content requirements Under mainland China's WTO commitments, the country is supposed to avoid setting local content requirements. This is meant to encourage the development of “spin-off effects” on local industry. Can protect inefficient local suppliers but without government protection there would be little chance for local industry to develop.
Foreign participation Auto manufacturing has to be conducted on a 50/50 joint venture basis. The government would like to protect domestic operators, as well as leverage foreign expertise. These joint ventures have enhanced efficiencies and allowed domestic manufacturers to learn new technologies.
Auto financing Mainland China announced plans to open its auto financing market to the non-banks in October 2003, fulfilling a WTO commitment. Auto financing will also be restricted by the government's tight control over interest rates. This could stimulate car demand, but absence of a personal credit rating system and regulations covering repossession could be a problem.
China's tenth five-year plan (2001-2005) The government has emphasized its intention to restructure and grow the auto industry. Key policies include creating two to three internationally competitive large-scale auto groups, encouraging cooperation with foreign investors and gradually phasing out protective regulations. The government has been successful in stimulating car demand and encouraging foreign investors. However, the industry remains highly fragmented.

Table 2

 

Chang'an Ford cut the prices of its compact Fiesta sedans by RMB10,000 (US$1,208)

If this trend continues, the key to retaining adequate profitability will be to improve production cost efficiency

An internationally competitive cost position would also be an important prerequisite for giving mainland China the opportunity to become an exporting country in the future, if the expected capacity is not fully used to serve domestic demand

Pressure from domestic manufacturers is also rising. In late 2002, Geely started to reduce the price of its small vehicle, resulting in it offering the cheapest subcompact in the country, a RMB38,900 (US$4,700) Haoqing hatchback, equipped with Geely's own engine and entirely locally made components. Overseas brands traditionally sell for at least RMB100,000 (US$12,082). Chinese auto manufacturer, Brilliance China cut the price of its Zhonghua sedan by up to 6.5% in 2003, bringing it down to the range from RMB157,800 (US$19,065) and RMB177,800 (US$21,481)

The price of imported vehicles remained high in 2003, as a result of fluctuations in foreign currency exchange rates and short supplies of import permits. According to the Chinese National Bureau of Statistics, the average price stood at US$27,088 during the first half of 2003, up from about US$23,000 during the corresponding period in 2002

Lust for Luxury Brings Premium Segment Growth Chances

In 1990, a massive 93% of the 45,000 vehicles produced in mainland China were medium or upper luxury class cars; governmental entities accounted for the overwhelming majority of vehicle purchases. As a result of an expanding consumer base, this mix has shifted to more than 40% for luxury vehicles in recent years. Despite this trend - which is expected to continue - the overall market growthhas resulted in mainland China now being the third-largest market in terms of unit sales for BMW's 7-series, behind the U.S. and Japan

DaimlerChrysler recently signed a euro 1 billion deal to make cars and trucks in mainland China with Beijing Automotive Industry Holding Co. under the Mercedes-Benz brand. GM is planning to relaunch the Cadillac luxury nameplate as both an import and domestically assembled brand in 2004

GM will offer both imported products and products assembled at its joint venture with SAIC. GM plans to build a select network to distribute and service Cadillac products in mainland China

New Regulations Pave Way for Automotive Financing

On Oct. 3, 2003, mainland China's Banking Regulatory Commission issued the Administrative Rules Governing Auto Financing Companies, paving the way for domestic and foreign companies to engage in providing car loans to customers. Volkswagen, GM, and Ford have made preparations for car finance businesses in the country. General Motors Acceptance Corp. (BBB/ Negative/A-2), GM's financial services subsidiary, applied for a license on Nov

12, 2003, and plans to offer wholesale and retail finance products

DaimlerChrysler Services has also announced plans to enter into the financing market. Banque PSA Finance (A-/Positive/A-2), a subsidiary of the PSA Peugeot Citroen Group, has recently been authorized by the China Banking Regulatory Commission to open a representative office in Beijing to support the local development of Peugeot and Citroën sales

Although car loans to individuals have increased sharply since 1998, only about 15%-20% of car buyers purchase with credit, compared with the global average of 70%. Standard & Poor's believes that there is significant growth potential, in line with the overall development of mainland China's financial markets. However, in line with the experience in other developing markets, the lack of available credit scoring data is an impediment and adds risk to consumer finance activities

Copycats and Legal Uncertainties Pose Risks

Another factor that needs to be considered when evaluating the risks associated with investments in mainland China is the legal uncertainty, including the risk of intellectual property violation. There are several examples of how difficult it is to protect proprietary technology, design, and trademarks in this legal environment. Toyota recently went to court over the wrongful use of its company logo and Honda is currently involved in a lawsuit against two motorcycle companies regarding trademark violation

The problem of copyright violation is even more pronounced for spare parts, where control is much harder and the copying of third-party technology and design may be easier to realize. VW, for example, is reported to have discovered that local suppliers copied parts used at SAIC's then affiliate, Chery. A strategy that had been popular among OEMs during the early days of investing in mainland China, the use of old technology and offering of previous season models to protect proprietary technology is now considered impossible to sustain, due to the increasing competitive pressures

Major Domestic Manufacturers in Mainland China's Auto Market

Shanghai Automobile Industry Corp (SAIC)

SAIC is based in the eastern region of mainland China. The company said its total car production exceeded 800,000 units in 2003. It holds two major joint ventures: Shanghai Volkswagen and Shanghai GM. The 50/50 joint venture with VW was created in 1985

Production is focused on the Santana, Passat, and Polo. Shanghai Volkswagen sold 396,006 cars in 2003, an increase of 32% over 2002. Shanghai GM was founded in 1997. It sold 201,188 units of its Buick sedans in 2003, 81.6% more than in 2002

First Automotive Works Corp. (FAW)

FAW is based in Jilin province, northeast mainland China. The company manufactures trucks, buses, and passenger cars. It holds a major joint venture with VW. FAW-Volkswagen sold 298,000 cars in 2003. The joint venture plant is being expanded to bring yearly capacity up to 330,000 from 300,000 units at present. Production is based around the Audi A6 and Volkswagen Jetta

Dongfeng Motor Corp. (Dongfeng)

Dongfeng, based in Hubei province, central mainland China, is the third largest auto manufacturer in the country. The company produced 470,300 autos in 2003. Dongfeng has a major joint venture with Citroen

Dongfeng and Citroen recently announced that it was planning to invest euro 600 million (US$759 million) to double the production capacity of its joint venture and introduce new models

The yearly capacity of the joint venture will increase to 300,000 units in 2006, from 150,000 units at present, according to Dongfeng President Miao Wei

Dongfeng also has a joint venture with Taiwan-based Yulong Motors Group, and it has been reported that the company is also negotiating with Renault to produce heavy trucks

Other domestic manufacturers

Mainland China produced 4.4 million autos in 2003, of which the top three manufacturers (SAIC, FAW, and Dongfeng) accounted for about 50%

Other significant domestic auto manufacturers include Tianjin Automotive industrial (Group) Ltd., Changan Automotive Co. Ltd., Guangzhou Automobile Group, Beijing Automotive Industry Corp., Geely Automotive Ltd., and Brilliance China Automotive holdings Ltd. A lot of these smaller companies have alliances with the large Asian manufacturers, such as Toyota, Hyundai, Nissan and Honda, which are expected to gain market share in the coming years

Chart 5

 

 

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