Infant Industry: Why Chinese Car Brands Are Struggling to Compete

China Economic Review, June 2012

Like many Chinese, Zong Zhaoxiang wishes nothing but the best for the Chinese car industry – yet he won’t be buying a Chinese car anytime soon.

The 52-year-old chairman of a Shanghai chemical company, Zong said he expects Chinese-branded cars to have bright prospects. However, he loves the comfort, quality and image projected by his black Mercedes-Benz S-class, and he said he may buy another Mercedes-Benz model or a BMW in the future. “If Chinese-made cars were better designed and could demonstrate your status, more people might buy them,” Zong said.

Not all of Zong’s compatriots can afford a Mercedes-Benz, of course. But most of them still prefer foreign brands to domestic ones. Volkswagen and General Motors sold the greatest number of vehicles in China in 2011, the world’s largest car market, followed by Nissan, Hyundai and Kia. All domestic carmakers combined captured only about 30% of their home market, the lowest proportion of any major economy.

This is not what Beijing intended. In contrast to other “strategic” industries like telecom and banking, the auto industry has been gradually opened to foreign investment over the past two decades, as Beijing allowed foreign car makers to form joint ventures with domestic partners. But the goal was always to help Chinese manufacturers acquire the technologies and expertise necessary to build their own strong brands, an outcome that eludes the industry.

As markets in the US and Europe stagnate, the focus of the auto industry has shifted to China. This has made Beijing’s efforts to build a strong global brand and profit from its own growth boom all the more urgent. “The sun of the automobile world is clearly shining in Asia and specifically in China,” said Geoff Broderick, Asia-Pacific general manager at auto industry consultancy J.D. Power & Associates. “[China] is clearly going to be the sales leader for the foreseeable future.”

Beijing aims to help Chinese companies capture about 50-60% of the market by 2015, but that goal appears unattainable. Chinese cars are variously accused of problems with quality, safety and styling, but their biggest problem continues to be brand strength – a conundrum that can- not be solved overnight.

“China is the world’s largest market, but it doesn’t make any of the world’s leading brands,” said an employee of Guangzhou’s Chang’an Auto who asked not to be named because he is not approved as a company spokesperson. “We’re hosts, not leaders.”

Race to the Bottom

State-owned car makers – such as Shanghai Automotive Industry (Group) Corporation (SAIC), First Auto Works (FAW ) and Chang’an Automobile Group – have begun paying more attention to building their own brands, at Beijing’s urging.

It’s been an uphill battle. With shorter histories, inferior technology and smaller marketing budgets, their products are mainly confined to the low-cost segment, where profits are thinner. Meanwhile, independent Chinese carmakers such as Geely, Chery, BYD and Great Wall have introduced their own low-price models, intensifying competition.

Most Chinese brands continue to trade on the China’s traditional forte: driving down manufacturing costs and making money on high volume and thin margins. In contrast, foreign car brands charge double or more and still sell far more units, all on the strength of their brand, technology and styling.

The playing field has tipped farther towards foreign players in the past few years. First, Beijing ended a tax break on cars with engines smaller than 1.6 liters last year. “The companies with smaller vehicles tend to be Chinese-branded carmakers. So they benefited most from the stimulus and were hurt the most by the removal of the stimulus,” said Bill Russo, a senior advisor at consultancy Booz & Co and the former head of Chrysler Asia.

The policy had helped overall vehicle sales to grow 46% year-on-year in 2009 and 32% year-on-year in 2010 – unsustainable rates of expansion, Russo said.

The termination of the tax break triggered both a slowdown in overall sales and a reduction in the market share of Chinese brands in 2011. Growth in sales of domestic cars fell to a 13-year low. The beating continued in the first quarter of this year: Overall sales of passenger cars declined 1.3% annually, while sales of Chinese passenger cars slumped 8.1%.

This drop in sales has prompted car companies to cut prices aggressively. Foreign auto makers are offering discounts of 25-30%, while some domestic auto makers have reduced prices by up to 50%.

Most Chinese companies are planning aggressive expansions in the next five to 10 years that will further increase competition.

“Overall profitability is strongly under pressure with the slowdown in the market,” said Ivo Naumann, managing director at consultancy AlixPartners.

“Going forward I think [Chinese car- makers] will have a very hard time. They will not be able to expand the market share on the low end much because of competition, and they have a very hard time moving up-market, where the quality and performance of the car plays a more important role.”

Holy Grail of the premium market

For Chinese carmakers, the key to winning over more domestic buyers is strengthening and elevating their brands. As luxury car owners like Zong Zhaoxiang attest, Chinese buyers often make purchase decisions based on a car’s ability to demonstrate their status.

Since cheap public transportation is widely available in Chinese cities, most Chinese buyers view cars as a luxury purchase, rather than a necessity, said Scott Laprise, an analyst at CLSA. “You get a lot of people in China who just never want to even buy a car until they can get a BMW.”

The result is that demand in the luxury car segment in China has been “upside down” compared with other markets, auto analyst Michael Dunne writes in “American Wheels, Chinese Roads: The Story of General Motors in China.”

In the US and Germany, sales of luxury cars decrease as the car’s price goes up, as one might expect. Mercedes’ C-Class sedan, its most affordable model, sells best, followed by the E-Class, and then the flagship S-class.

Until very recently, however, this order was reversed in China: the S-class (Zong Zhaoxiang’s chosen ride) was the bestseller, followed by the E-Class and then the C-class. This changed only four years ago, when Mercedes localized production of the C- and E-Class sedans. These two models are now significantly cheaper than the S-Class because they are not subject to a 25% import duty, said Dunne. However, “China remains the No 1 S-Class market worldwide, and it still makes a powerful statement when it pulls up in front of the Portman Ritz Carlton or Shanghai Links Country Club.”

Shang Yugui, a vice president and spokesman at Chinese SUV maker Great Wall, agreed that brand is a powerful motivator. “Chinese consumers’ under- standing of cars has improved, but they’re still not very rational. Chinese consumers are not buying a car; they’re not buying its functions. They are buying face. That’s very obvious in big cities.”

Chinese brands are understandably eager to chase this demand by moving their brands up-market. But building a luxury brand is difficult and time-consuming – perhaps even impossible, said Philippe Houchois, an auto analyst at UBS.

The last brand to rise into the luxury segment was Lexus in the 1980s in North America, he said. Outside of North America, however, Lexus is often still not recognized as a premium brand. “I think brands exist or they don’t, but you don’t make new [luxury] brands anymore. They’re very historic, and it’s difficult to create new ones,” Houchois said.

Slow going

The luxury segment may be off-limits, but some Chinese companies have been able to move somewhat up-market.

SAIC successfully entered the high-end market in the last few years with the release of “Roewe,” a brand based on intellectual property acquired when British car maker MG Rover went bankrupt in 2005. Geely, a private carmaker that acquired Swedish brand Volvo in 2010, has also won market share by gathering its high-end products together under one nameplate, “Emgrand.”

Overall, however, few Chinese car- makers have been able to establish a reputation for quality and comfort. Sometimes this is merely a matter of lagging consumer perception (see chart on page 36), but often there are still quality and technology gaps between foreign and Chinese brands.

For example, many Chinese companies have yet to master the technology for building automatic transmissions (Geely is an exception, having acquired Australia’s Drivetrain Systems International, the world’s second-largest automatic trans- mission company, in 2009). Chinese car brands also tend to lag behind in terms of styling, marketing and after-sales service.

“The fact is that the quality is not yet completely there,” said Naumann of Alix- Partners. “[Chinese manufacturers] have made great progress over the last seven to eight years, but they are not yet there.”

Analysts said many Chinese companies also tend to face operational challenges. Even if a company has mastered advanced technologies, they may still have trouble designing a car as a logical package, creating an efficient business model to support it, and then fitting that car into a complementary portfolio of products.

“Improving technology is no longer the problem. The problem is now how to turn technology into a widely competitive product,” the Chang’an employee said. “How to transform first-rate technology into classic products, how to transform classic products into best-selling products – that’s not just a question of technology, but of marketing and management.”

Long road ahead

Several Chinese companies are ahead of the pack in mastering these processes. Geely and SAIC, for example, both posses strong technology and have intro- duced higher-end brands. And while the track record of SOEs like FAW, Dongfeng Motor and Guangzhou Auto have been unimpressive thus far, Scott Laprise of CLSA said he expects them to benefit in the long run from their access to foreign brands and technology they derive from their foreign joint ventures.

Many analysts are also bullish about Great Wall, an independent brand that concentrates on SUVs and pick-ups.  Laprise praises the company for its strong exports, good brand recognition, quality and cash position. State-owned carmaker Chery has also introduced some competitive models, like the Riich and the Regal, though Huaibin Lin of consultancy IHS Automotive cautioned that the company has had problems with management and cost control.

Overall, Chinese car companies are making progress. Most analysts acknowledge that it will just be a matter of time before they catch up. “The Chinese brands will clearly have the same level of quality and styling as the foreign ones do [in the future],” said Broderick of J.D. Power & Associates. “And as soon as their brand equity catches up, then I think you will see more of a growth rate of Chinese brands.”

Unfortunately, this could take a long time. Most industry people project that Chinese carmakers will need another five to 10 years to perfect their processes and technology, and perhaps more time to solidify their brand. To make the shift, Chinese car makers will need to change their focus from quantity during the boom years to quality now, said Luo Lei, deputy secretary-general of the China Automobile Dealers Association.

As a result, the market share of Chinese carmakers will probably increase only gradually in the years to come and fall far short of Beijing’s target of 50-60% market share. IHS Automotive projects Chinese manufacturers will capture 37-38% of the domestic market by 2020, up from around 30% currently.

“Some voices are still casting doubt on the development of independent brands ... Consumers just need to be a little patient – we’ll mature and progress,” said the Chang’an employee.

Spend money to make money

One factor that could speed this process is outbound acquisitions. The surest way for Chinese companies to get ahead seems to be by acquiring foreign brands and technology – as Geely did with Volvo and Drivetrain Systems International, and SAIC did with MG Rover.
“I think, left alone, nothing changes.

Chinese auto makers ... wouldn’t make much progress,” said Michael Dunne, the author of “American Wheels, Chinese Roads.” “But they have enough political will that they could start acquiring more brands. Volvo’s already there, there was an effort to buy Saab. You could see, for example, Chrysler or Dodge or Fiat or Hugo or Citroen or weaker global brands get acquired.”

Of course, that raises the question of whether these companies would qualify as “Chinese brands.” Would Beijing accept an acquired foreign brand as the domestic champion that it has been searching for? Perhaps China’s central planners can take heart in the fact that the situation swings the other way. By setting up shop in China, multinational car makers are, to a certain extent, also becoming Chinese operations. Laprise of CLSA cited the example of General Motors, which has localized management and parts production in China, and even designs half of its worldwide platforms in Shanghai. “What is GM in China? A Chinese carmaker or a foreign carmaker? I mean that philosophically,” he said. “You’re paying all these people in local salaries; you’re reinvesting a vast majority of your profits into the local entity. What is not Chinese about Shanghai GM?”
  Even Mercedes-Benz, that paramount of car quality, is localizing production of its luxury models.  Its Beijing Benz joint-venture assembles and manufactures the E-Class and C-Class in China; someday this may be joined by the flagship S-Class.

Perhaps the next time Shanghainese businessman Zong Zhaoxiang buys a Mercedes-Benz, it will be a little more “Chinese” than the last time.