China and Autos decentralization and competition in an exploding market

1. Note that I skipped many slides in my class presentation. Feel free to ask followup questions at: Msmitka@wlu.edu If you are not using a W&L account, it could get trapped in the new spam filter -- I always acknowledge emails quickly, so if you don't hear from me, send it from another account! China and Autosdecentralization and competition in an exploding market Spring 2007, Shanghai Washington & Lee University Study Abroad Trip

2. Two tasks • Teach you more about China • Prepare you to ask a real expert good questions (Alyssa Webb) (Maybe teach a little economics, too)

3. Projections, June 2004 PwC Autofacts

4. Reality, 2006 surpassed 2011 projections

5. US China Japan India Mexico Korea Russia Germany Brazil France UK Italy

6. Political economy + Industrial Organization • Early auto industry: ford's position • Monopoly! • Then GM, Chrysler • Oligopoly • Now Toyota, Honda, Nissan • And imports, all with multiple models • Monopolistic competition • Zero (economic) profits, excess capacity, high distribution costs (advertising, inventory) • Choice is costly…

7. So how about China? • What do you see on the road in Shanghai? • When you got into a taxi, what make was it? • A VW Santana, right? • So how many car producers under Mao? • Initial single Soviet plant in Manchuria ca. 1958 • But then decentralization • Entering modern period = • 119 firms! • Each part of a local monopoly

8. Excess entry • Initially one Soviet plant in Manchuria • Based on a Fiat plant • But also regional military plants from late 1940s • But extreme decentralization under Mao • "3rd Front" policy put production in remote areas in case Russia invaded • Party rewarded output • Industry counted (but not quality!) • services didn't • agriculture was grain first

9. All 30-odd provinces had plants • Trucks of course were primary • But also cars • Motorcycles, motorbikes • Various tractor-like 2-, 3- and 4-wheelers • How was that possible • Look at Shanghai's roads: • VW Santana still large share • Look at Beijing's roads • Even though it is the #1 vehicle in China • You'll see almost no VW Santanas!

10. Political Success from output • Not efficiency! • Local protectionism • Huge employment levels in the aggregate • By that measure, China is #1 in world • Productivity began improving in the 1990s • But still pressure to buy local • And military / government demand too • Plus not (yet) at international efficiency levels • Big jump since 2000 • Economies of scale -- more later

11. So how many firms now? • No good count! But … in all likelihood more! • So 120+ firms • Why no exit? • Growth allows all to survive • For now…! With help by local governments and banks • Compare that to the US market entering WWI, smaller than China's market yet dozens of firms • Role of suppliers: assemblers, well, assemble! • And market • And (sometimes!) design • Contrary to central government policy! • Which has long and unsuccessfully pushed consolidation

12. However… • A few success stories developing • VW but lots of Buicks in Shanghai • Guangdong significantly richer • Honda and Nissan and now Toyota • 4 domestics stand out • Chery, Brilliance, Geely, SAIC • Three delta regions (my sense) • Pearl River (south), Yangtze (mid), Yellow (north) • Sichuan as a potential 4th region • But everyone else trying, Anhui doing well!

13. Market structure shifting • Trucks and luxury vehicles at start • Chauffeured vehicles • Now mid-sized a big share, plus minivans etc (especially corporate use) • New segment: compacts at $7000-$10,000 • Still a luxury, but lots of rich Chinese • Sales are now greater so do China's middle/upper class families outnumber Japan's population!? • regional producers with small, cheap vehicles • Also inexpensive

14. Market remains fragmented

15. Region x segment • Fragmented market! - only 2 firms have a double-digit share • 20 non-Chinese firms • 29 substantial Chinese firms • 49 firms total! • 14 have sales over 100,000 units • 6 have sales over 250,000 • VW, GM, Honda, Chery, Hyundai, Toyota • 1 has sales over 500,000: VW exit, yes, but still new entry

17. Some adjustment already • No longer does everything sell • Obscene initial monopoly prices gone • Profit margins were 30%!! • Now prices down 20% for many models • VW as representative monopolist • No new models • Indifferent quality • Slow to respond when market changed • But in general capacity constraints • Which won't last forever

18. Sustainable? • Some exit over time • Some already … Fiat venture up for sale? • M&A strategy (maybe) to consolidate regionals? • 6.15 million units in 2006 and growing • US at 16-17 million still much larger • But Germany Japan France all smaller • Fragmentation! • New models at roughly 1 per week • But still less than US with 650 models? • Yet industry benefits from economies of scale • So a contradiction?

19. Many will survive • Fierce competition, will be surprising successes • For now hard to fail, will have many producers • Compare to Big Six in US, plus Little Six, plus imports • Some will end up in bad niches / mismanage JVs • Much will hinge on government policy • Environment! • Auto industry an easy political target everywhere • Unique strategies echoing 1910s in US

20. Assembly is not all • Everwhere… • Parts employment at least 2x assembly • Assemblers assemble • Parts producers make • Parts producers engineer • Parts producers enjoy economies of scale • Outside China, Magna may adopt same • Looking to buy Chrysler!

21. Parts production • Key to the industry • All the major players are here • 75 of top 100 global firms • 1,200 foreign and joint-venture plants total! • Can have 100% subsidiaries, unlike assembly • Delphi has 500+ engineers • More than some car assemblers! • Experience & capacity growing rapidly

22. Industrial geography • Asia needs parts producing capacity • Duh, Chinese market up 20+% in Q1 of 2007 • India, ASEAN (Assoc Southeast Asian Nations) growing too • You have to add capacity somewhere! • Implicit rule of thumb: • Assemble where you sell, make parts nearby • But a long transition to accomplish that! • China not low cost for labor intensive parts! • Nor is it always low cost against existing plants • But it beats a new plant in Japan or Korea! • Not to mention Germany and

23. Other ancillary industries • In aggregate 3x manufacturing • Repairs and service • A big segment • old & poor quality vehicles • Hard use on rough roads • NO info … but maybe you can find some? • Yellow Hat of Japan seeking to enter? • Dealers • Largely ignorant about those in China • But will meet Infiniti people • Lots of consultants, professional marketing • Dealerships can be a real estate play, too

24. Policies • Lots of imports at different points in time (Kia!), but now small share of market (250,000) • Strong pressure for joint ventures • Constant tensions • Some Chinese firms have multiple subsidiaries • More than one foreign partner • Ambitions to launch vehicles on their own • Barriers (perceived & real) encouraged entry Probably too successful for own good

25. Autos and Energy • Energy demand rising at +2.3% per year • Hence doubles in 30 years ["rule of 72"] • No growth 1996-2000 • Why so low? • After all, GDP growth is huge! • 7%-11% implies economy doubles in • ≈ 10 years at 7% • < 7 years at 11% • Old rule of thumb: elasticity ≥1.0 ["elasticity"=?]

26. Nature of energy demand • Less heavy industry • New firms use higher quality energy sources • Less crude sources by households & others • More urban • more energy efficient than rural • But (duh!) more autos • So weight of petroleum up • China now a net importer • 1979 exports ==> big push development strategy failed • Cf. perestroika in USSR … parallels & contrasts

27. Why poor link? • Legacy of planned economy • Prices are administered • Starting efficiency levels abysmal • 80% poor quality coal in 1980 • Still 56% • Electricity, petroleum • 13% and 24% respectively

28. Now transition over? • Initial economic reforms (as in USSR) premised on energy exports • Petroleum and coal • Former never panned out, now latter nil • So net importer • Petroleum up 15% to 20% pa • Small share of world total at 3.5% • But with low growth elsewhere, large share of incremental demand

29. How will change? • Better quality coal • will be source for electricity • Motor vehicles petroleum for next 2 decades • Electric vehicles in urban, low-distance areas • Fits China?! • Hydrogen a long ways away? • But no existing gasoline infrastructure so sensible? • Government policies can push easier than in US / EU • Hybrids not viable • Silly to put 2 power plants and battery in a small vehicle

30. Autos and Pollution • 16 of world's 20 most polluted cities • SO2, NO2 , CO, ozone, PM (particulate matter) • In a short breath, smog • Est. 590,000 excess deaths a year! • Tianjin health impact 3.7% GDP (US$1.1bil) • Even though pollution cut by 10+% • Source 50-80% from motor vehicles • Additional congestion time losses • Only recent switch to unleaded fuel • Additional hidden costs from brain damage

31. Energy: sum • Motor vehicles will account for about • 60% of demand in 2020 • Improving efficiency even 1% has impact! • Easy political target

32. Big push for electric cars • Good for within-city transport • Uses night-time generating capacity • Peak load is daytime • So electricity providers have huge strategic & management challenge that this helps • Technically feasible in short-run • But government also favors hybrids • Maybe irrationally so

33. Is it good policy? • Maybe … shifts location of emissions away from urban areas • Key for smog, as in LA (electric plants downwind in NV) • Maybe not be lower overall emissions • depending on details • Electricity can potentially be cleaner • May not save energy or cut CO2 • Lots of waste across entire electricity chain • But electric engines pretty efficient • Batteries an issue; government can mandate

34. Political salience • Consumers "understand" cars • Not technical electric power grid issues • Few producers so administratively easy • Though China stretches the definition of "few" more than anyone! • Also licenses etc etc make policy easier to implement • Autos are a sexy industry • Sex is OK in politics • but fouls up decision making (a polite 4-letter "f" word)

35. Lessons? 1 of 2 • Legacy of extreme decentralization • Interesting strategy issues • Entry game with lots of players • long-run reality of monopolistic competition • Until then, really profitable - for some • Extreme competition • Survivors may have unusual skills and strategies • 35% of GM's advertising is for internet chat rooms

36. Lessons? 2 of 2 • Political economy • Auto industry everywhere politicized • At least in post-WWII era • Lots of externalities but • Direct auto policies not always best • Biggest sector (parts!) escapes attention • Sheer diversity makes regulation hard

37. Conclusion • Transport as a positive externality • Without transport, markets can't function • Motor vehicles offer flexibility trains don't • Without transport, poverty • Poor rural residents vastly outnumber urban poor • Transport is ONE element of development • A necessary(but not sufficient) component • Assignment • judge the infrastructure you encounter • Vehicles (making selling servicing) isn't the issue!