China: The Domestic and the Global Industry

In October 2013 sales in China reached 1.92 million units – see the China Auto Industry Association statistics page for details. That's just shy of a 24 million unit rate, and is surely the largest number of vehicles ever sold in a single market in a month. For GM, sales were 282,000 units – 25% more than US sales that month. Everyone is in the market, or preparing to enter there. The Korean neighbors (Kia and Hyundai, but also Daewoo as part of GM), Japan (or at least the Japan Three of Toyota, Honda and Nissan, and Mazda and Suzuki), Germany (BMW, Mercedes, VW), the Detroit Three and now the French, both PSA and Renault. A host of local firms continue, though most as paper entities. Still, Great Wall, Chery, Geely, BYD, Changan and others.

This raises a host of questions. I focus on two: geography and profitability. I frame my brief analysis using the perspective of the OEMs. Since more and more value added lies with suppliers, that may lead to inappropriate conclusions, but for now I will accept the status quo terms of debate.

...the geography of China's automotive industry makes no economic sense...

First, despite very large production volumes, a side effect of government policy has been to disperse production widely. Even though the Third Front policies of the 1960s are widely understood to have been a failure, the political economy of joint venture approvals has led to factories in locations that make little sense. Today, with the market supply-constrained, that matters little. As competition heats up, however, the costs that accompany scattered locations will become more and more burdensome.

Second, there's profitability. On a global basis, the dark secret is the industry depends on the US market for a disproportionate share of profits. Japan's domestic market is in long-term secular decline, and will remain fundamentally unprofitable despite the dominant position of Toyota. (Suppliers seem to be able to collude with impunity – or so they thought – but Toyota hasn't been successful in being a price leader.) Europe is little better, offset only because of a richer product mix. How profitable is China? To my mind that is the single more important strategic variable the industry faces.

Back to geography. Under Mao local governments were expected to fend for themselves, first and foremost in terms of food but extending to a wide variety of industrial products. Fearing a Soviet attack, Mao deliberately dispersed heavy industry into remote locations. So at the onset of post-Mao reforms, every province and most large cities turned out trucks and passenger cars, even if only a handful a year. In total there were perhaps 120 producers. But political power was likewise dispersed; up-and-coming party officials were rotated through a variety of posts, but anyone slated for top leadership served a stint as a provincial governor or mayor of a prefectural-level city such as Shanghai. To be promoted to the senior leadership in Beijing required presiding over economic growth. So when the government looked to joint ventures to improve motor vehicle production, the result inevitably was one factory here, another there. Local protectionism – in Shanghai you found old generation VW Santanas, in Beijing you found jeeps – reinforced this desire to have your own plant.

China has no equivalent to the 600-mile-long I-75 "automotive alley" in the US, with an agglomeration of suppliers, assemblers and associated engineering centers feeding off of each other in a positive manner. Beijing is 1,300 miles from Guangzhou [Canton] in the south, and several automotive operations are another 400 miles to the northeast of Beijing. Similarly, at the western end of the zone is Kansas City, 700 miles from Detroit and 650 miles from Columbus, OH; Chengdu in the Sichuan basis is 1,200 miles to the west of Shanghai, across rough terrain, and Urumqi is 2,400 miles away.

Perhaps Wuhan will become a nexus – a recent Automotive News China story – but there is none at present at the assembler end. Perhaps suppliers are more concentrated, I know of several engineering centers in Shanghai, proximate to those of VW and GM, the two largest car companies in China. But what this means is that as competition heats up, and the segmentation of the country into regional markets eases, there will be numbers of plants whose location will saddle them with high logistics costs coming and going. As long as the government mandates joint ventures, politics will trump sensible plant siting. The geography of China's industry makes no sense, and will cost firms money.

...GM's & VW's Chinese ventures appear to be quite profitable....

Then there's profitability. Perhaps some suppliers break China out as a separate geographic region, but I've yet to find any. (My understanding is that parts suppliers are not under the stricture of forming joint ventures, though likely many of them have because local partners add value.) Assemblers however are limited to joint ventures, and at the two market leaders (GM and VW) their profits are accounted on an equity basis, rather than as part of normal operating profits. Both however provide that number. It's likely to be an underestimate. The biggest potential divergence would be if these ventures paid dividends; that would reduce retained earnings and the rise in book value. That is, equity income falls, though it would be offset by dividend income. However, neither media reports nor financial statements provide any hint of such payments. Indeed, it's clear that at present all funds are being reinvested. Instead, the (post-tax) equity income is an overstatement because both venture partners have an incentive to use transfer pricing to the hilt, as they get 100% of any excess, but only half if they let the venture book a lower price and higher profits. On the Chinese side that includes the provision of real estate; for VW and GM it would include licensing fees for intellectual property. Both firms have relatively new facilities, and continue to invest at a prodigious pace; they likely have high offsets for depreciation. And of course GM and VW can only report half of total profits.

To the numbers: in the first 9 months of 2013 GM International Operations, under which China falls, realized equity income of $1.4 billion; total consolidated GM profits were $4.3 billion, so the Chinese joint ventures accounted for 32% of the total (and 32% of unit sales). Another way to view the China side is to compare profits in North America with profits in China. GMNA is 6% larger unit sales, and GM China lacks the gold mine of full-sized pickups. But given GM's 50% share, GM's joint ventures in China earned $2.8 billion while North America pulled in $2.2 billion. China makes money.

VW's numbers paint a similar picture. The increased equity valuation of VW's China operations came to €3.5 billion in the first 3 quarters of 2013; total profits were €8.8 billion. China thus accounted for 40% of the total, on 32% of global volume. Of course at present Europe weighs down VW's profits. Nevertheless given its 50% stake, its joint venture partners in China earned €7.0 billion. Its operations are older than those of GM, so it will have lower depreciation charges; its Santana plant in Shanghai, which contained used equipment, is likely fully amortized. Its Audi brand is also the dominant luxury vehicle in China. Still, at roughly US$9 billion it substantially out-earned GM. The bottom line again is that China makes money.

So perhaps we will move towards a bipolar world, in which North America and China come to dominate global automotive profits. As the industry is currently structured, though, China's geography will remain an impediment.

Thanks to David Wiest for discussing equity accounting with me.

Energy Futures

The challenge of "green" is aggregating small amounts of energy – ultimately days of sunlight per surface^[1] – into amounts useable in quantity and continuity. Plants convert some of that energy continuously in daylight hours, but aggregating is the challenge. Currently we rely almost entirely upon a fossil fuel process that takes eons and is not sustainable – even if the amounts of recoverable fuels remains large, the environmental side effects are rising, not falling. Global economic growth has almost immeasurable benefits – hundreds of millions of Chinese no longer face hunger daily. Only recently has the government sufficiently overcome the fear of famine to eliminate the mandate that farmers grow grain. In China point- and regional-source pollution is now sufficiently bad to generate local political action, as it was first in California and then in the US as a whole in the 1960s. But no local government, and most national governments, are uninterested in denying access to electricity (air conditioning, refrigeration, lighting) or mobility (cars). Desirable or not, I don't think it's realistic to expect that governments will do much to repress energy demand. Supply-side developments are thus crucial. That means improving the feasibility of solar, wind, hydro and biomass.

One challenge is operational size. To what extent are economies of scale so intrinsic in the physics (and their engineering implementation) that only large facilities are feasible? Let me speculate on alternatives for wind power to frame this question.

Currently the trend is towards very large turbines. Winds blow stronger above ground; if you're building a tall tower, you then want to generate a lot of power per tower to cover costs. That may work, with better engineering of blades and generators and mechanical connections. Scale on the manufacturing side can help, as standardized designs lead to economies in production, from poles to turbine blades.

What would a small system look like, something found in every backyard? First, the turbines would have to be short and spin on a vertical rather than a horizontal axis; they couldn't look like windmills, but rather spinning windpoles that would face different wind sheer and so might be cheaper structurally – the pole would be the turbine access, with lower stresses cheap bearings or even bushings would do. Now close to the ground they'd "enjoy" far less wind, so would have to be really cheap. Windpoles might be relative to windmills on a watt-hour basis.

Then there's the aggregation issue. Such windpoles probably couldn't each turn a generator, that would be too high in cost per unit of energy. They might however be able to turn a small scroll compressor that would feed through standard lines to a centrally located turbine. Scroll compressors are pretty well understood, there are lots of refrigerators and air conditioners out there. Storing compressed air is also a mature technology, providing a means to enhance continuity. Small air tools – small turbines – have also been around a long time. So the pieces could be assembled quite readily.

I'm not enough of an engineer to cost any of this out. There may be simply too little wind energy at ground level. But versions of this – systems whose cheapness and small size make up for conversion efficiency – seem worth exploring. Perhaps they already have been, and have been found wanting. But in some parts of the world small rooftop solar water panels are pervasive – highly inefficient in the amount of energy they convert but so cheap as to make sense.

...[we'll see] a multiplicity of energy systems … [as in] vehicle drivetrains

In any case, any attempt to move away from fossil fuels is likely to lead to a multiplicity of energy systems – just as we are currently seeing a growing variety of vehicle drivetrains, depending on local fuel options and driving patterns.

mike smitka

Note 1. Nuclear – including geothermal – and tidal sources are exceptions. While in principle fusion is possible only uranium-based fission is commercially available, but that suffers from both political and economic pressures that make it a small slice of currently harnessed energy. Geothermal and tidal energy are at present unimportant.

China: all's well ... for now

Today VW claimed sales of 2.35 million units in Jan-Sep. Meanwhile GM's PR machine releases brand sales monthly. I track these, out of curiousity and because I teach a course on the Chinese economy (in which I use Michael Dunne's American Wheels as one of 4 books I ask students to read). GM's 9-month total is ... 2.35 million units.

At one level it seems rather silly for a manufacturer to seek to be the market leader – after all, you can typically boost sales through aggressive discounting, and while a price war is great for consumers and car dealers, it's really, really bad for manufacturers. However, journalists find "who's first" makes good copy, and from a corporate perspective that's free PR. Does it solidify brand image and encourage people to shop your vehicles? Maybe. But whether being first is a good image to create among potential consumers is at base an empirical question, about which I've not the foggiest idea.

it seems rather silly ... to seek to be the market leader

Let's think about this from another perspective. [I round everything – these are back-of-the-envelope calculations.] Given market growth, another 3 months ought to add another 35% and 40% to their annual total – let's call it 6.5 million units between the two. With a total market of perhaps a bit under 20 million this year, and somewhat less if we focus on passenger-oriented vehicles, that comes to a 35% market share.

Now in the hypercompetitive US market Ford and GM, the top two firms, have a combined market share of 34% over the past 12 months. If we expand to the Big Three – GM, Ford and Toyota – their joint share is 48%, down over the past several years. I don't track the Chinese market closely enough to have put together a spreadsheet; my sense is that Ford (story here) is growing its share, while Hyundai and Nissan are strong (and Toyota weak). The purely domestics are much, much smaller though Great Wall with its Haval (web site here, Bloomberg story here) has what is by far the best-selling SUV.

In a market expanding as fast as China's it's possible to preserve margins despite this level of rivalry. First-movers can push down costs and try to build share, thinking of the long run. But in that long run the market will likely have more brands and certainly more manufacturers than either NAFTA or the EU. Once sales slow, profits will plummet towards the global normal, which is such as to make being an assembler barely sustainable.^{Note 1} [The parts sector is different in that regard, with far few players for many of the major vehicle systems.]

That will be worse news for some, because virtually all production in China is through joint ventures.^{Note 2} As long as the market is expanding, well, that can be made to work. However, joint ventures are inherently unstable, and when – not if – profits disappear, China will prove no exception. (Indeed, while I know of no breakdown the past few years, in an earlier era Beijing Jeep imploded, and a Peugeot venture stalled. Indeed, an October 14th Bloomberg story notes they may sell a portion of their stake in 3 factories jointly owned with Dongfeng, among other measures designed to raise cash amidst the 6th year of declining sales in the EU.)

It's common to find policymakers thinking of technology as a set of blueprints. In that case, transferring technology is a function of bargaining power. In the real world, however, it's the ability to engineer a car. That is "embodied technology" in the literal sense: it requires building a large team backed by sophisticated management and computer tools for purchasing and other functions. Some firms, notably GM, have chosen to build such capabilities in their ventures, while stressing that the ventures remain independent from either partner. For now GM can use a variety of strategies to increase its own returns – China is part of its global operations, and the vehicles sold in China rely on engineering done elsewhere covered by licensing fees. The longer run though is that it will become more and more a stand-alone operation, paying less in fees to outsiders and even generating some revenue from its own engineering efforts. GM (and SAIC and other partners) will become shareholders, and finesse the underlying tensions of the joint venture structure.

GM [may] finesse the ...tensions of ... joint venture[s]

However, my educated guess^{Note 3} is that GM has been far more proactive than other ventures. So along with falling profits I predict rising feuds. Chinese government policy in principle promotes fewer players and the pursuit of economies of scale (while in practice proving unable to prevent new entry, most recently through formal permission to allow the domestic assembly of Volvos). There used to be 120 or so domestic makers, but now there are only a few dozen, and some of those exist mainly on paper, selling trivial numbers. Given the instability of joint ventures, though, for some ventures the road ahead will be bumpy and may in fact lead to a dead end. In the coverage I read of the Chinese market, I see an almost single-minded focus on sales and rates of expansion. I read almost no analysis of whether that expansion is taking the right path.

Note 1: for economists, think "monopolistic competition".

Note 2: For general background see China Auto Web. Then there's Automotive News China. Others obviously cover this, such as a nice IBT article. After all, how can you not write about the world's largest car market?

Note 3: I use the phrase "educated guess" very deliberately. I read a lot and strive to integrate that using the analytic skills for which a PhD represents but one step. However, while my Chinese is sufficient for navigating web sites and is improving, my reading speed is still too slow to be a practical research tool – unlike my Japanese and German.

mike smitka

Japan's Headlines: China not Clunkers

Mike Smitka

The top headline in the Nikkei today (Aug 7th) was neither their recession, nor their pending general election (and the potential change of government). It was July car sales in China, up 64% from from 2008 to roughly 1.1 million units. That's above the clunker-driven 1.0 million level in the US, and (as the percentage increase suggests) out of synch with sales doldrums during the past couple summers.
Part of the reason is that, despite the American perception of China as an economy dominated by exports, it's a country the size of the continental US, and that huge domestic expanse is peopled by 1.3 billion would-be consumers. The Chinese government is determined that they will be consumers. To make that happen, the government is providing plenty of domestic stimulus, unhindered (at least in comparative terms) by domestic banking problems, and with little of the pointless tax cuts and other fluff that bolstered the price tag of the "stimulus" package passed in the US. The ongoing construction of a national highway system provides plenty of room to speed things up (reversing the policy stance of a year ago, when the fear was inflation).
There are also vehicle-specific policies with bigger environmental implications than the US program that gets rid of a few seldom-driven¹ "clunkers." Their tax breaks and and scrappage incentives (that include provisions to help rid rural roads of smoke-belching 3-wheelers), was implemented in a timely manner in January 2009. The focus is small vehicles, those with under 1600cc engines, with no loopholes to subsidize the purchase of trucks (unlike the US "clunkers" program). And if you visit Shanghai or Suzhou, while you'll find the roads filled with scooters and motorized bikes, the noise level is a fraction of what it used to be: they're electric, driven by batteries. The garages of condos include outlets to plug them in at night, enough to power the daily commute. But diesel fuel in China is still sulfur-laden, so the next-best alternative, a clean-diesel powered vehicle, is not yet an option there -- as was the case until two years ago in the US. So China can't (yet) follow the European option of small, clean and very-long-lived diesel powered cars.
Now the China market is profitable for the moment, and important to global firms. GM has actually shifted its international operations HQ to Shanghai, anticipating its sales there to top 1 million units in the near future; VW already sells over 1.0 million units a year. Accordingly everyone is pouring on capacity and dealers.
This may be a "bubble" of sorts. Already the shift towards smaller vehicles makes it less of a gold mine than a year ago on a per-vehicle basis. Meanwhile, the number of players is mind-boggling: not only are all of the major international players in the market (VW and GM have the top two spots) but there are still 80 local players. Yes, 80 -- because local governments support their "favorite son" firms. If you visit China, watch how the make of taxis varies as you move from city to city. The government is pushing for consolidation, and a couple of the bigger players have bought up a couple small ones. Others have quietly exited. But consolidation has been policy for years and years, and still there are 80 firms! Unless push comes to shove, Beijing has all too little clout at the local level, and this is just one example.
Lots of players ultimately means little profit. GM, Toyota and their rivals are jointly placing a big bet that that does not happen until they've been able to recoup their investment. However, that's a game of "chicken" and at the moment no one wants to blink and ease off on the throttle. I smell a bloodbath in the making, red ink puddled all over balance sheets. That may be 3 years away, but it will happen.
Meanwhile lots of incumbents remain due to (local) government largesse. A couple will turn out to have been well run and innovative, though at present they are still woefully lacking in engineering sophistication. In the background Beijing -- not the locals -- is making a big push towards electric vehicles; ditto battery technology. So a few local firms are likely to focus on electric vehicles (not nightmarishly complex hybrids), and in a market where drivers don't expect to go hundreds of kilometers at a stretch, there will be a local market (unlike in the US). The transition in drivetrain technologies may allow a couple global players to emerge out of the current plethora of small, high-cost producers.
Note that this has strong parallels with the Japanese case. There government policy also pushed for consolidation, and it also failed to accomplish that. Now the early post-WWII market did have about 30 players, and without local government support [Japan's is not a decentralized political system] or other deep pockets half of them soon exited; Toyota and Nissan both picked up with an extra factory or two in the process. The bottom line however was a market with a dozen firms, no dominant firm or even a "Big Three" that could mute competition. In Japan, it was improve efficiency or fail, and in the end that gave birth to Honda and Toyota.² Japan's auto industry succeeded because industrial policy failed; the same, I suspect, will prove the case in China.³
Notes
1. Unfortunately the mandatory "CARS" survey that is part of the US "clunkers" program doesn't ask how many vehicles were owned. It does ask how many miles were driven the previous year -- as far as I can tell, no data from that question are yet available. Not surprising: most dealers haven't been able to get their "clunker" deals approved, much less gotten a check.
2. There are of course other Japanese firms, but only Honda, Toyota and Suzuki remain autonomous. Nissan is controlled by Renault, Mazda is de facto controlled by Ford, Fuso is owned by Daimler, Nissan Diesel by Volvo Truck, Toyota has purchased Hino and Daihatsu outright and has a large stake in Subaru/Fuji Heavy and Isuzu, and MMC has survived through the inexplicable largesse of its creditors and of Mitsubishi Heavy Industries.
3. I have only cursory knowledge of India. In contrast, I began studying about China in 1971, and while I ultimately became a Japan expert (more practical at the time), I've followed (and taught a course on) the Chinese economy for over 20 years, and have visited the country repeatedly.

Too Big To Fail

A quick line, a take on Paul Krugman's latest (April 2, 2009) NYTimes Op/Ed on China and the US:

Their stance -- and that of the rest of the world -- is that they don't like what they see [US macro fundamentals], but we (the US) are too big to fail.