Foreign Direct Investments:

Volkswagen’s Entry Strategy in

China’s Car Market

21/1/2013
 Content Page

Table of Contents
Abstract.......................................................................................................................................................1
Introduction................................................................................................................................................1
Literature review.........................................................................................................................................2
Volkswagen rational for China – Dunning’s Eclectic Paradigm...................................................................4
Conclusion...................................................................................................................................................6
References...................................................................................................................................................7
Abstract

China is one of the most attractive destinations for Foreign Direct Investments in the
world. It is first destination for Inward FDI among developing countries (WTO, 2012). China has
developed second world’s largest car market after U.S.A. and has been the largest car producer in
the world since 2008.

German company Volkswagen (hereafter VW) is the world’s second largest motor vehicle
manufacturer after Toyota Motor (CNN, 2012) and the biggest manufacturer in Europe. VW is
one of the earliest investors and the biggest foreign car maker in China with 15% of market
shares. This report, by applying relevant theories, such as Dunning’s eclectic paradigm or
Hymer’s internationalization theory, will explain why VW Company decided to invest in China
through joint venture rather than acquisition or Greenfield investment.

Introduction

Chinese car industry, as well as many other branches, is very young, although dynamic
and fast growing. In 1978 Chinese government introduced policy of open doors which allowed
foreign companies to invest and operate in China. Since then car sector has developed rapidly
from an infant to a mature industry. Moreover, Chinese government provides various incentives in
order to attract foreign firms invest in Chinese car market, which the cause for industry dramatic
development.
VW entered Chinese market in 1984 setting up joint venture with the Shanghai Shanghai
Auto Works which created Volkswagen Automotive Company Ltd. This was shortly followed by the
Volkswagen Automotive Company Ltd in Changchun in 1990. Simultaneously European and North
American markets had become more and more competitive and consolidated. Therefore, many
car companies decided to globalize, mainly aiming BRIC countries (Brazil, Russia, India,
China). Volkswagen has proved its role as one of the leaders in global car industry gaining
biggest share in Chinese car market (focuse2move, 2012). This report, thorough literature
review, will explore on FDI models and theories that try to explain why companies decide to
enter foreign market. This will be followed by case study which is going to analyze
Volkswagen’s entry strategy when entered China and answer why it was the best solution.
Finally, the conclusion part will analyze company’s future and potential opportunities.
Literature review
FDI has been defined by the World Trade Organization as occurring “when an investor in
one country (the home country) acquires an asset in another country (the host country) with the
intent to management that asset” (WTO, 1999). This definition emphasises importance of the
compilation Balance on Payment accounts. FDI have become important element of companies’
expansion in the era of globalization. Multinational Enterprises (MNE) take international
operations in order to set up their presence in other country. Stonehouse (2004) classified
Foreign Direct Investments into following categories:

- Wholly owned subsidiary with Greenfield or acquisition/mergers

- Joint Ventures (Figure 1).

On the other hand, non-MNE can advantage from globalisation through export/import,
franchising/licensing, outsourcing or FPI (Foreign Portfolio Investment). As Peng (2011) argues
“what sets MNEs apart from non-MNE is FDI”. What makes MNE different from non-MNE is
active involvement in managing foreign operations. This gives weight to the aspect of control.
Moosa (2002) stated that “the distinguishing feature of FDI, in comparison with other forms of
international investment, is the element of control over management policy and decisions.” In

accelerating global environment MNE have become more and more popular.
Figure 1: Types of FDI

Hymer (Jones, 2006) developed theory of monopolistic advantage to explain motivation

for control in direct investments. Investor’s engagement and control over foreign enterprise and
production activities will bring more benefits rather than investment portfolio. He pointed on two
reasons, either of which apply, are expected to increase profits. First, firm removes competition
within industry, through acquisition or mergers with firms in foreign markets. Second, the firm
gains advantage over other firms operating in a foreign country by applying more cost efficient
manufacturing process, marketing and advertising techniques, known how, organizational skills
that are not available or a product that is not known in the host country. Both reasons stress
importance of “market imperfections.”
 Buckley’s and Casson’s internationalization theory is one of the most famous theories
which tries to explain why MNE go international. According to Klug (2006) firms can take two
types of international transactions, on the market via exporting or licensing and international
operation via FDI. Taking into account cost factors firm can increase profits from replacing
(imperfect) external market until the benefits of the further internationalization are higher than
costs. In other words, due to imperfection of foreign markets and efficiency reasons firm can
locate its operation in different countries. As Forsgren (2008) pointed that “the overriding issue
is still cost efficiency rather than power in the market.”

The oligopolistic reaction theory explains determinants of firm’s strategic international

reactions to the behavior of its oligopolistic competitors. Knickerbocker (1973) pointed out that
in this environment actions of one player will bring the reaction of other firms. This leads to the
“following the leader” rule, where companies in order to stay competitive in international market
will invest in the same market and in the same time than other big players. As Barclay noticed
(2002) it possesses the elements of defensive strategy where some of the big companies try to
minimize risks of losing competitiveness and to protect access to valuable production factors.

In 1966, Raynond Vernon (Peng, 2009) developed product life cycle theory. He
categorized life of product into three stages within three different markets. First, new product
stage, where products is introduced within innovative market in order to meet market’s demand.
In second, maturing product stage, product saturates innovative market and firms expand into
other developed countries in order to find new customers. In the last stage, standardize product
stage, where product becomes commodity and markets become price sensitive, firms are
motivated to move to low-cost production countries in order to bring production costs down.
This theory explains relation between product’s life cycle and the flow of FDI.

One of the most famous theories that explains FDI is Dunning’s eclectic paradigm.
Dunning (2000) states that firm will invest directly in other country only if it meets three
conditions. It gives relatively comprehensive explanation of the motives of MNEs’ FDI, and
various internationalization activities like location selection, market entry mode preference and
etc. Author was able to connect monopolistic advantage and internationalization theories and add
location specific aspect creating OLI advantages (Jones, 2006):

1. Ownership-specific advantages can include things like knowledge, technology,

management and organizational system, size of the firm that gives foreign company
specific advantage over host companies. In this way Dunning relates his paradigm to
the Hymer’s monopolistic advantage theory.

2. Location-specific advantages that are specific to a particular country but it is

available for all firms and it relates to the natural resources, costs of labor force and
cultural, political and legal environment.
3. Internalization advantages are the ways that a firm maximizes the gains from
internationalize their specific ownership advantages (especially intangible assets) to
avoid or overcome external market imperfections.
 Using those three factors firm try to find the answer for the “why” the “where” and the
“how” go for FDI. After taking into consideration those three factors company decides which
way will be the best for the market entrance.

Volkswagen rational for China – Dunning’s Eclectic

Paradigm.
Volkswagen has already operated 100 production plants in 18 European countries, and other
nine countries out of European, which have America, Asia and Africa (Figure 2). Now, VW has
nearly 501,956 employees, in every working day it can produce over 34,500 vehicles, and sells its
vehicles in more than 150 countries. (Volkswagen AG, 2013).

Figure2: VW global activity.

As a one of the global market leaders, VW possesses complex product portfolio including
nearly all classes of cars, which extend from low-consumption small cars to luxury class vehicles.
(Volkswagen AG, 2013). The Group now consists of ten major brands, which include Volkswagen
Passenger Cars, Volkswagen Commercial Vehicles, Audi, Bentley, Seat, Skoda, Bugatti, Scania, Man
and Lamborghini. Except Volkswagen Passenger Cars brand, rest of them have been bought in the
form of acquisition between 1964 and 2012.

Using OLI’s paradigm we can provide the most comprehensive answer about VW’s
decision to invest directly in China as it covers argumentation provided by other authors of FDI
theories such as Hymer’s monopolistic advantage or Buckley’s and Casson’s internationalization
theory. Dunning’s eclectic paradigm fully explains how German carmaker benefited from
ownership-specific advantage, internalization advantages and additionally from location-
specific advantages. It provides more detailed answer not only on what VW gained by investing
in China but also it helps to understand why VW decided to enter Chinese market through joint
venture rather than acquisition or mergers which is the most favorable strategy of the company.

Ownership-specific advantage. Entering China, VW decided to enter joint venture with

two the biggest car makers in the market. German company has contributed to the joint venture
with capital resources, technology and knowledge of production process. That allowed them to
produce high quality, small compact cars perfectly suited for Chinese developing market. On the
other hand, VW was able to eliminate potential competency overcoming market imperfections.
Also, introduction of VW’s corporation policy played essential role in creating successful and
competitive enterprise. Success of Shanghai Volkswagen has been achieved due to development
of their employees. In 2007, the joint venture gained the title of “Best Companies to Work for in
China” (Volkswagen AG, 2009). All of these factors helped company to keep control on process
of production and protection on the product. This led VW to reach position of the market leader
described in Hymer’s monopolistic advantage theory.
Location-specific advantages. As the most populous country China offered two major
advantages from production perspective and potentially very attractive market. Host country
could provide great number of or low cost labor. Moreover as a collective-mind society, Chinese
were able to adopt to VW’s corporate policy. From the other hand, Chinese market with its
bicycle society represented great opportunity for the car market in the future. VW was able to
take first-mover advantage as the one of the earliest companies invested in Chinese car market.
Due to right, however risky, decision VW is still a leader in car market today. However, VW had
to take into consideration potential risk related to the investment in China. Despite the
introduction of open doors policy in the end of 1970’s, Chinese government did not want to lose
control in the market. Therefore the only possible way for VW to invest in the market was to
enter joint venture with Shanghai Automotive Industry Corp which keep 50% of the shares.
When second joint venture operation took place in the early 1990’ and FAW-VW was
established, VW got 40% of the shares. This was the result of the government policy to help
develop domestic car market using technology, known how and organizational skills of foreign
partners.

Internalization advantages. Despite the fact VW has not reached the major shares in its
enterprises in China, it was still the best solution for German company in order to gain costs
efficiency. On the one hand though the policy of open doors tariffs for imported cars where
almost 30%. That situation made exporting option unprofitable. Additionally potential low cost
of the production played important role. By entering the joint venture with two the biggest
carmakers operating in China VW were able to achieve economy of scale and economy of scope.
Through internationalization operation in China VW was able to control execution and
application of their owner’s specific advantages. This relates to imperfection of foreign markets
and efficiency reasons represented by Buckley’s and Casson’s internationalization theory.
Conclusion
Through the research it was found that Volkswagen’s favorite entry strategy is acquisition
in order to build competitive advantage in the new market. As MNE VW has achieved this
through obtain of cheaper resources in the new markets like Mexico, Brazil or India. They
explore their foreign enterprise, purchased or build their own foreign plants.

However, attracted by fantastic opportunities in China, VW has entered the market

through joint venture mostly due to political environment. In spite of opening policy since 1978,
Chinese government has been aiming at development of their domestic car industry. None of
new foreign investors is allowed to obtain major share in the Chinese companies and have to
play role of the assistant supporting development of the Chinese car technology. However, the
government and VW gained mutual advantage from joint venture. VW helped Chinese
government to reach the position of second the biggest car market in the world and improve car
production technology due to entrance of strong German’s R&D team. On the other hand
Chinese market has become second the biggest market for VW cars in terms of sales after
Germany. However, in some people’s opinion VW has to redefine their strategy if it wants to
keep the position of market leader. Critics of VW’s future in China stress the fact of few core
strength and demoded management team of German’s carmaker. Currently it seems that VW is
happy from benefits and future opportunities that come from China’s WTO compliance, still
impressive market growth or Chinese government’s more and more pro-FDI attitude.
Nevertheless Chinese car market is a dynamic environment which change every year. Therefore
VW has to be ready for increasing threats such as increasing competitions from both
multinational and domestic car companies. Moreover, rapidly developing Chinese society might
cause increasing pressure from customers for more diverse products.

China is one of the most attractive investments destinations for the world investors. VW is
one of the first foreign investors and the biggest foreign automobile manufacturer in China, with
shares of 15% of the Chinese car market in terms of sales. This report analyzed VW’s entry mode in
China and provided an answer for what was the rational for such decision. Despite the VW
preferences for acquisition mode as an entry strategy it decided to use joint venture in China.
Although it seemed that it was the best and most preferable option, further arguments provided proof
of Chinese politic environment that was responsible for the VW decision of joint venture strategy.
Finally in conclusion it was stressed that VW will have to face not only further benefits from
operations in China but also many new challenges.
References

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