Competing in the Chinese Automobile Industry

Integrative Case 2.X for GLOBAL BUSINESS (Peng 1E)

© Qingjiu (Tom) Tao

Integrative Case 2.X

COMPETING IN THE CHINESE AUTOMOBILE INDUSTRY1

Qingjiu (Tom) Tao

Lehigh University

The Red-hot Market

For automakers seeking relief from a global price war caused by overcapacity and recession,

China is the only game in town. With just ten vehicles per 1,000 residents in China as of 2006 (as

opposed to 940 in the United States and 584 in Western Europe), there seems to be plenty of growth

opportunities. Not surprisingly, nearly every major auto company has jumped into China, quickly turning

the country into a new battleground for dominance in this global industry. In addition, China has become

a major auto parts supplier. Of the world's top 100 auto parts suppliers, 70% have a presence in China.

China vaulted past Japan in 2006 to become the world’s number-two vehicle market (after the

United States). In 2006, car sales in China were up 37%, and sales of all vehicles including trucks and

buses (7.2 million in total) were up 25%. Reports of record sales, new production, and new venture

formations were plenty. After China’s accession to the World Trade Organization (WTO) in 2001, the

industry has been advancing by leaps and bounds. At the global level, China has moved to the third

position in production behind the United States and Japan, and is slated to produce 8.5 to 9 million

vehicles in 2007. Around 50% of the world’s activity in terms of capacity expansion is seen in China.

[Insert Exhibit 1]

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This case was written by Qingjiu (Tom) Tao (Lehigh University). © Qingjiu (Tom) Tao. Reprinted with
permission.

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 Competing in the Chinese Automobile Industry
Integrative Case 2.X for GLOBAL BUSINESS (Peng 1E)
© Qingjiu (Tom) Tao
Because the Chinese government does not approve wholly owned subsidiaries for foreign

carmakers (even after the WTO accession), foreign firms interested in final-assembly operations have to

set up joint ventures (JVs) or licensing deals with domestic players. By the mid-1990s, most major global

auto firms had managed to enter the country through these means (Exhibit 2). Among the European

companies, Volkswagen (VW), one of the first entrants (see below), has dominated the passenger car

market. In addition, Fiat-Iveco and Citroen are expanding.

[ Insert Exhibit 2 ]

Japanese and Korean automakers are relatively late entrants. In 2003, Toyota finally committed

$1.3 billion to a 50/50 JV. Guangzhou Honda, Honda's JV, quadrupled its capacity by 2004. Formed in

2003, Nissan's new JV with Dongfeng, which is the same partner for the Citroen JV, is positioned to

allow Nissan to make a full fledged entry. Meanwhile, Korean auto players are also keen to participate in

the China race, with Hyundai and Kia having commenced JV production recently.

American auto companies have also made significant inroads into China. General Motors (GM)

has an important JV in Shanghai, whose cumulative investment by 2006 would be $5 billion. Although

Ford does not have a high-profile JV as GM, it nevertheless established crucial strategic linkages with

several of China’s second-tier automakers. DaimlerChrysler’s Beijing Jeep venture, established since the

early 1980s, has continued to maintain its presence.

The Evolution of Foreign Direct Investment (FDI) in the Automobile Industry

In the late 1970s, when Chinese leaders started to transform the planned economy to a market

economy, they realized that China’s roads were largely populated by inefficient, unattractive, and often

unreliable vehicles which needed to be replaced. However, importing large quantities of vehicles would

be a major drain on the limited hard currency reserves. China thus saw the need to modernize its

automobile industry. Attracting FDI through JVs with foreign companies seemed to be ideal. However,

unlike the new China at the dawn of the 21st century which attracted automakers of every stripe, China in

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the late 1970s and early 1980s was not regarded as attractive by many global automakers. In the early

1980s, Toyota, for example, refused to establish JVs with Chinese firms even when invited by the

Chinese authorities (Toyota chose to invest in a more promising market, the United States, in the 1980s).

In the first wave, three JVs were established during 1983-84 by VW, American Motors,2 and Peoguet, in

Shanghai, Beijing, and Guangzhou, respectively. These three JVs thus started the two decades of FDI in

China’s automobile industry.

There are two distinctive phases of FDI activities in China’s automobile industry. The first phase

is from the early 1980s to the early 1990s, as exemplified by the three early JVs mentioned above. The

second phase is from the mid-1990s to present. Because of the reluctance of foreign car companies, only

approximately 20 JVs were established by the end of 1989. FDI flows into this industry started to

accelerate sharply from 1992. The accumulated number of foreign invested enterprises was 120 in 1993

and skyrocketed to 604 in 1998 with the cumulated investment reaching $20.9 billion.

The boom of the auto market, especially during the early 1990s, brought significant profits to

early entrants such as Shanghai VW and Beijing Jeep. The bright prospect attracted more multinationals

to invest. This new wave of investment had resulted in an overcapacity. Combined with the changing

customer base from primarily selling to fleets (government agencies, state-owned enterprises, and taxi

companies) to private buyers, the auto market has turned into a truly competitive arena. The WTO entry

in 2001 has further intensified the competition as government regulations weaken. Given the government

mandate for JV entries and the limited number of worthy local firms as partners, multinationals have to

fight their way in to secure the last few available local partners. By the end of 2002, almost all major

Chinese motor vehicle assemblers set up JVs with foreign firms. For numerous foreign automakers which

entered China, the road to the Great Wall has been a bumpy and crowded one. Some firms lead, some

struggle, and some had to drop out. The leading players are profiled below.

2
American Motors was later acquired by Chrysler, which, in turn, was acquired by Daimler to form
DaimlerChrysler. More recently (in 2007), DaimlerChrysler divested the Chrysler part. Between 1983 and 2005, the
JV in China maintained its name as “Beijing Jeep Corporation” while experiencing ownership changes. In 2005, its
name was changed to “Beijing Benz-DaimlerChrysler Automotive Co., Ltd.” At the time of this writing (late 2007),
it is not clear how the JV’s name may change further to reflect the divestiture of Chrysler.

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[ Insert Exhibit 3 ]

Volkswagen

After long and difficult negotiations that began in 1978, VW in 1984 entered a 50/50 JV with the

Shanghai Automotive Industrial Corporation (SAIC) to produce the Santana model using completely

knocked down (CKD) kits. The Santana went on to distinguish itself as China’s first mass produced

modern passenger car. As a result, VW managed to establish a solid market position. Four years later,

VW built on its first-mover advantage and secured a second opening in the China market when the central

authorities decided to establish two additional passenger car JVs. After competing successfully against

GM, Ford, Nissan, Renault, Peugeot, and Citroen, VW was selected to set up a second JV with the First

Auto Works (FAW) in Changchun in northeast China in 1988 for CKD assembly of the Audi 100 and the

construction of a state-of-the-art auto plant to produce the VW Jetta in 1990.

Entering the China market in the early 1980s, VW took a proactive approach in spite of great

potential risks. The German multinational not only committed enormous financial resources but also

practiced a rather bold approach in its dealings in China. This involved a great deal of high-level political

interaction with China’s central and local government authorities for which the German government

frequently lent its official support. Moreover, VW was willing to avail the Chinese partners a broad array

of technical and financial resources from its worldwide operations. For example, in 1990 VW allowed

FAW a 60% in its JV while furnishing most of the manufacturing technology and equipment for its new

FAW-Volkswagen Jetta plant in Changchun. Moreover, VW has endeavored to raise the quality of local

produced automotive components and parts. Undoubtedly, for the remainder of the 1980s and most of the

1990s, VW enjoyed significant first mover advantages. With a market share (Shanghai VW and FAW

VW combined) of more than 70% for passenger cars over a decade, VW, together with its Chinese

partners, benefited considerably from the scarcity of high-quality passenger cars and the persistence of a

seller’s market.

However, by the late 1990s, the market became a more competitive buyer’s market. As the

leading incumbent, VW has been facing vigorous challenges brought by its global rivals which by the late

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1990s made serious commitments to compete in China. Consequently, VW’s passenger car market share

in China dropped from over 70% in 1999 to 39% in 2004. In 2005, GM took the number one position in

China from FAW VW. How to defend its market position thus is of paramount importance.

General Motors

In 1995, GM and SAIC, which was also Volkswagen’s partner, signed a 50/50, $1.57 billion JV

agreement—GM’s first JV in China—to construct a greenfield plant in Shanghai. The new plant was

designed to produce 100,000 sedans per year, and it was decided to produce two Buick models modified

for China. The plant was equipped with the latest automotive machinery and robotics and was furnished

with process technology transferred from GM’s worldwide operations. Initially, GM Shanghai attracted a

barrage of criticisms about the huge size of its investment and the significant commitments to transfer

technology and design capabilities to China. These criticisms notwithstanding, GM management

reiterated at numerous occasions that China was expected to become the biggest automotive market in the

world within two decades and that China represented the single most important emerging market for GM.

Since launching Buick in China in 1998, GM literally started from scratch. Unlike its burdens at

home, GM is not saddled with billions in pensions and health-care costs. Its costs are competitive with

rivals, its reputation does not suffer, and it does not need to shell out $4,000 per vehicle in incentives to

lure new buyers—even moribund brands such as Buick is held in high esteem in China. Consequently,

profits are attractive: The $437 million profits GM made in 2003 in China, selling just 386,000 cars,

compares favorably with $811 million profits it made in North America on sales of 5.6 million autos. In

2004, GM had about 10,000 employees in China and operated six JVs and two wholly owned foreign

enterprises (which were allowed to be set up more recently in non-final assembly operations). Boasting a

combined manufacturing capacity of 530,000 vehicles sold under the Buick, Chevrolet, and Wuling

nameplates, GM offers the widest portfolio of products among JV manufacturers in China. Seeing China

sales rise 32% to nearly 880,000 vehicles, GM recently announced plans to build hybrids in China.

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Integrative Case 2.X for GLOBAL BUSINESS (Peng 1E)
© Qingjiu (Tom) Tao
Peugeot

Together with VW and American Motors (the original partner for the Beijing Jeep JV), Peugeot

was one of the first three entrants in the Chinese automobile industry. It started to search for JV partners

in 1980 and in 1985 set up a JV, Guangzhou Peugeot, in south China. The JV mainly produced the

Peugeot 504 and 505, both out-of-date models of the 1970s. While many domestic users complained

about the high fuel consumption, difficult maintenance, and expensive parts, the French car manufacturer

netted huge short-term profits at approximately $480 million by selling a large amount of CKD kits and

parts. Among its numerous problems, the JV also reportedly repatriated most of its profits and made

relatively few changes to its 1970s era products, whereas VW in Shanghai reinvested profits and refined

its production, introducing a new "Santana 2000" model in the mid-1990s. Around 1991, Guangzhou

Peugeot accounted for nearly 16% share of the domestic passenger car market. But it began to go into the

red in 1994 with its losses amounting to $349 million by 1997, forcing Peugeot to retreat from China. It

sold its interest in the JV to Honda in 1998 (see below).

While the sour memories of the disappointing performance of its previous JV were still there,

Peugeot (now part of PSA Peugeot Citroen) decided to return to the battlefield in 2003. This time, the

Paris-based carmaker seemed loaded with ambitious expectations to grab a slice of the country's

increasingly appealing auto market sparked by the post-WTO boom in the auto industry. One of its latest

moves in China is an agreement in 2003 under which PSA Peugeot Citroen would further its partnership

with Hubei-based Dongfeng Motor, one of China's top three automakers which originally signed up as a

JV partner with Citroen, to produce Peugeot vehicles in China. According to the new deal, a Peugeot

production platform will be installed at the Wuhan plant of the JV, Dongfeng Citroen. Starting from 2004,

the new facility has turned out car models tailored for domestic consumers, including the Peugeot 307,

one of the most popular models in Europe since 2003.

Honda

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© Qingjiu (Tom) Tao
Peugeot's 1998 pullout created a vacuum for foreign manufacturers which missed the first wave

of FDI into this industry. These late entrants included Daimler-Benz, GM, Opel (a German subsidiary of

GM), and Hyundai. Against these rivals, Honda entered and won the fierce bidding war for the takeover

of an existing auto plant in Guangzhou of the now defunct Guangzhou Peugeot JV. The partner selection

process had followed a familiar pattern: Beijing was pitting several bidders against each other to extract a

maximum of capital, technology, and manufacturing capabilities, as well as the motor vehicle types

deemed appropriate for China. Honda pledged to invest $887 million and committed the American

version of the Honda Accord, whose production started in 1999. Two years later, Guangzhou Honda

added the popular Odyssey minivan to its product mix. In less than two years, Honda had turned around

the loss-making Peugeot facility into one of China’s most profitable passenger car JVs.

It is important to note that well before its JV with the Guangzhou Auto Group, Honda had

captured a significant market share with exports of the popular Honda Accord and a most effective

network of dealerships and service and repair facilities all over China. These measures helped Honda not

only to attain an excellent reputation and brand recognition, but also strengthened Honda’s bargaining

power with the Chinese negotiators.

Emerging Domestic Players

The original thinking behind the Open Door policy in China’s auto market by forming JVs with

multinationals was to access capital and technology and to develop Chinese domestic partners into self-

sustaining independent players. However, this market-for-technology strategy failed to achieve its

original goal. Cooperation with foreign car companies did bring in capital and technology, but also led to

over-dependence on foreign technology and inadequate capacity (or even incentive) for independent

innovations. By forming JVs with all the major domestic manufacturers and controlling brands, designs

and key technologies, multinational companies effectively eliminated the domestic competition for the

most part of the last two decades. Only in the last few years did Chinese manufacturers start to design,

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produce, and market independent brands. In 2006, domestic companies controlled some 27% of the

domestic market (mostly in entry- to mid-level segments). They have become masters at controlling costs

and holding prices down, with a typical Chinese auto worker earning $1.95 an hour against a German

counterpart making $49.50 an hour.

Ironically, the breakthrough came from newly established manufacturers without foreign

partners. Government-owned Chery (Qirui) automobile, which started with $25 million using second-

hand Ford production equipment, produced only 2,000 vehicles six year ago.3 In 2006, it sold 305,236

cars, a surge of 118% over 2005, with plans to double that again by 2008. Privately owned Geely Group

obtained its license only six year ago and began with crudely built copycat hatchbacks powered by

Toyota-designed engines. With an initial output of 5,000 cars in 2001, Geely today produces 180,000 a

year, with various models of sedans and sports cars, including those equipped with self-engineered six-

cylinder engines. Beyond the domestic market, Chery

now exports cars to 29 countries. In 2006, the company produced 305,000 cars and exported 50,000.

Chery cars are expected to hit the European market later in 2007. It signed a deal with DaimlerChrysler

that will see it produce Dodge-brand vehicles for the US and Western Europe markets in the near future.

Geely Group plans to buy a stake in the UK taxi maker Manganese Bronze Holdings and start producing

London’s black taxis in Shanghai. It also aims to sell its affordable small vehicles in the US within

several years. In an effort to get closer to overseas

markets, the Chinese players are starting to open overseas factories, too. Chery has assembly operations

in Russia, Indonesia, Iran, and Egypt. The company now is planning to extend its reach in South America

by opening an assembly plant to produce its Tigo-brand sport-utility vehicle in Uruguay. Brilliance

3
In May 2005, GM sued Chery in a Chinese court for counterfeiting the design of a vehicle developed by GM’s
South Korean subsidiary Daewoo. While this case created some media sensation, in November 2005, the parties,
encouraged by the Chinese government, reached “an undisclosed settlement.” The settlement terms were not
revealed. It was not known whether Chery had to pay for its alleged infringement or whether it was barred from
using the purportedly infringing design (http://iplaw.blogs.com/content/2005/11/gm_piracy_case_.html).

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produces vehicles in three overseas factories in North Korea, Egypt, and Vietnam, and Geely has a

factory in Russia.

The Road Ahead

Looking ahead, the tariff and non-tariff barriers will gradually be removed in post-WTO China.

Increasing vehicle imports after trade liberalization will put pressure on the existing JVs which assembly

cars in China, and will force them to improve their global competitiveness. Otherwise, locally produced

vehicles, even by JVs with multinational automakers, with no advantage as regards models, prices, sales

networks, components supply, and client services, will have a hard time surviving.

Despite China’s low per capita income overall, there is a large, wealthy entrepreneurial class with

significant purchasing power thanks to two decades of economic development. The average price of

passenger cars sold in China in 2004 is about $20,000, whereas the average car price in countries such as

Brazil, India, and Indonesia is $6,000-8,000. China, for example, is BMW’s biggest market for the most

expensive, imported 7-Series sedan, outstripping even the United States—even though Chinese buyers

pay double what Americans pay and often in cash.

However, vehicle imports will not exceed 8% of the market in the foreseeable future. China’s

automobile industry, which has almost exclusively focused on the domestic market, still has much room

for future development and will maintain an annual growth rate of 20% for the next few years. In the long

run, as domestic growth inevitably slows down, there will be fiercer market competition and industry

consolidation. The entry barrier will be higher and resource development will be more crucial to the

sustainability of the competitive advantage. In order to survive and maintain healthy and stable growth,

China’s JV and indigenous automobile companies, having established a solid presence domestically, must

be able to offer its own products that are competitive in the global market.

No doubt, the road to success in China’s automobile industry is fraught with plenty of

potholes. As latecomers, Hyundai, Toyota, Honda, and Nissan had fewer options in the hunt for

appropriate JV partners and market positioning than did the first mover VW during the 1980s. All the

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© Qingjiu (Tom) Tao
way through the early 1990s, foreign auto companies were solicited to enter China and encountered very

little domestic competition or challenge. This situation has changed significantly. Today the industry is

crowded with the world’s top players vying for a share of this dynamic market. Success in China may

also significantly help contribute to the corporate bottom line for multinationals which often struggle

elsewhere. For example, China, having surpassed the United States, is now Volkswagen’s largest market

outside of Germany. In 2003, one-quarter of Volkswagen’s corporate profits came from China.

There are two competing scenarios confronting executives contemplating a move into China or

expand in China: (1) At the current rate of rapid foreign and domestic investment, the Chinese industry

will rapidly develop overcapacity. Given the inevitable cooling down of the overall growth of the

economy, a bloodbath propelled by self-inflicted wounds such as massive incentives looms on the

horizon. (2) Given the low penetration of cars among the vast Chinese population whose income is

steadily on the rise, such a rising tide will be able to list all boats—or wheels—for a long while at least.

[Sources] Based on (1) W. Arnold, 2003, The Japanese automobile industry in China, JPRI Working Paper No. 95;
(2) Economist, 2003, Cars in China: The great leap forward, February 1: 53-54; (3) G. Edmondson, 2004,
Volkswagen slips into reverse, Business Week, August 9: 40; (4) H. Huang, 1999, Policy reforms and foreign direct
investment: The case of the Chinese automotive industry, Fourin, 9 (1): 3-66; (5) M. W. Peng, 2000, Controlling the
foreign agent: How governments deal with multinationals in a transition economy, Management International
Review, 40 (2): 141-166; (6) Q. Tao, 2004, The Road to Success: A Resource-Base View of Joint Venture Evolution
in China’s Auto Industry, Ph.D. dissertation, University of Pittsburgh; (7) D. Welch, 2004: GM: Gunning it in
China, Business Week, June 21: 112-115; (8) G. Zeng & W. Peng, 2003, China’s automobile industry boom,
Business Briefing: Global Automobile Manufacturing & Technology 2003, 20-22. (9) E. Thun, 2006. Changing
lanes in China. (10) D. Roberts, 2007, China’s auto industry takes on the world, Business Week, March 28.

Case Discussion Questions

1. Why do all multinational automakers choose to use FDI to enter this industry? What are the drawbacks of
using other entry modes such as exporting and licensing?
2. Some early entrants (such as Volkswagen) succeeded and some early entrants (such as Peugeot) failed.
Similarly, some late entrants (such as Honda) did well and some late entrants (such as Ford) are struggling.
From a resource-based standpoint, what role does entry timing play in determining performance?
3. From an institution-based view, explain the initial reluctance of most multinational automakers to enter
China in the 1980s. Why happened which made them to change their mind more recently?
4. If you were a board member at one of the major multinational companies, you have just heard two
presentations at a board meeting outlining the two contrasting scenarios for the outlook of the Chinese
automobile industry in the last paragraph of the case. Would you vote “Yes” or “No” for a $2 billion
proposal to fund a major FDI project in China?

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//B4CASEFINALChinaAutoTomTao0709//9/6/2007//3718words//

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Exhibit 1. Automobile Production Volume and Growth Rate in China (1996-2006)

Year 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006
Volume 1.475 1.585 1.629 1.832 2.068 2.347 3.251 4.443 5.070 5.718 7.280
(Million)
Growth rate 1.5% 7.5% 2.8% 12.5% 12.9% 13.2% 38.5% 37.7% 14.1% 12.8% 27.3%

[Source] Yearbook of China’s Automobile Industry (1996-2006).

Exhibit 2. Timing and Initial Investment of Major Car Producers

Forma- Initial Investment Foreign Chinese Partner Foreign Partner

tion (Million Dollar) Equity
Beijing Jeep 1983 223.93 42.4% Beijing Auto Works Chrysler
Shanghai Volkswagen 1985 263.41 50% SAIC Volkswagen
Guangzhou Peugeot 1985 131.4 22% Guangzhou Auto Group Peugeot
FAW VW 1990 901.84 40% First Auto Works Volkswagen
Wuhan Shenlong Citroen 1992 505.22 30% Second Auto Works Citroen
Shanghai GM 1997 604.94 50% SAIC GM
Guangzhou Honda 1998 887.22 50% Guangzhou Auto Group Honda
Changan Ford 2001 100.00 50% Changan Auto motors Ford
Beijing Hyundai 2002 338.55 50% Beijing Auto Group Hyundai
Tianjin Toyota 2003 1300.00 50% First Auto Works Toyota

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Exhibit 3. Evolution of Relative Market Share Among Major Auto Manufacturers in China

Evolution of Relativ

0.8000

0.7000

0.6000

0.5000
Market Share

0.4000

0.3000
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