China: The Car Story
China: The Car Story
Andy Xie (Hong Kong)
The car market illustrates how the market mixes cyclical and secular trends and over-invests in China. In my view, a price war in the car industry seems inevitable, as capacity growth has far outstripped demand growth. The price war would force producers to cut costs and improve efficiency, which paves the way for China to become a major exporter in the coming years. The development of the auto industry, while painful for overzealous investors, likely will enhance China's competitiveness in the end.
Unrealistic expectations are also working in the property market, with a lag. The fallout from the property market, however, likely will be more negative for the economy. Its inventory is far larger than the auto industry’s. The inevitable decline in property prices will damage the financial system, in my view. And there is little potential competitiveness gain for the country from an overextended property sector.
Potential vs. Reality
Sedan production in China has registered negative annual growth for the past two months, and sales have grown at a single digit for five months compared to 72.3% last year. It appears that the sedan market could not revive high growth without some fundamental changes.
I wrote about the great potential of China's auto market in 2002 (see 'Fifty Million Cars', July 19, 2002). The buildup of the national highway system and rising urban income were the catalysts for the takeoff. But I also cited commoditization and competitive prices as the key industry features for the auto industry to realize its potential.
The key weakness of China's sedan market is its high prices, which are higher than in Japan — a country with per capita income 30 times China's. But the market was growing very rapidly in 2002 and 2003 despite the high prices. The industry players and financial investors believed that, with penetration so low, the high price and high growth could last for many years. The equity market, for example, gave the industry a lot of capital to expand capacity. The global players also increased capacity rapidly.
Exports Will Revive the Auto Industry
China can become the lowest-cost producer for the auto industry, as it is for light-manufacturing industries. The auto parts industry is quite labor-intensive. As parts account for most of the production cost, China has the potential to become the lowest-cost producer and a major platform for export production by global companies. Currently, China's production costs are still higher than the international average due to imported components and low scale economies.
The key to China's success, therefore, is in creating a big parts industry. The domestic market for sedans is about 2 million, twice as big as Korea's. It is already big enough for a big parts industry to emerge, in my view.
The coming price war in the car market will force major producers to search for cheap local parts. That will be the catalyst for the industry to take off. The process could be quite similar to what happened in the household appliance industry. The scaling-up of the parts industry allows producers to cut prices, which increases domestic demand. The rising demand allows the parts industry to scale up more to cut prices further.
The declining production cost and declining prices spiral would eventually turn China into the lowest-cost producer for sedans. When prices are so low, this will trigger global companies to apply the outsourcing model to this industry, as happened in the home appliance industry. A number of global car companies can focus on R&D, design and marketing and leave production to their subcontractors based in China.
The Three Phases of a New Market
When a new market takes off, there will be high growth and high prices in the first phase, because it is penetrating high-income population first. The high-income population is quite small. My guesstimate is that 15 million households have annual disposable income above $10,000 and own most of the private wealth in China. The mistake that the market usually makes is to extrapolate this initial trend of high price and high growth into 1.3 billion people and, hence, to increase capacity rapidly.
In the second phase, the businesses with too much capacity try to cut costs and prices to increase sales to keep capacity utilization high. This naturally leads to (1) taking advantage of China's cheap labor to localize production and (2) scaling up even further to sustain sales by continuously cutting prices. As prices fall, the market begins to penetrate the medium-income population (with household income around $5,000 per annum). If technologies permit, the penetration could even reach low-income population, as the home appliance and mobile phone industries have been able to do.
In the third phase, the major industry players realize that they could make more profits by exporting. When localization reaches a sufficient level, the production cost of a product begins to fully reflect China's labor cost, which is substantially lower than in other major industrial economies. The major players in other market markets also realize that they can make more money by outsourcing production to China.
For example, China has become the dominant producer in home appliances. The global players that were producing and selling before are now only selling. The consumers may not realize that the products under the same brands are now made in China and are happily benefiting low prices.
The auto industry could follow the same path. I see no major reasons why the auto industry could not follow the shoe or refrigerator industry to go down the outsourcing path. Indeed, outsourcing is potentially the only path I see for the US auto industry to regain competitiveness.
The Property Market Is Repeating the Car Story
China's property market is repeating the mistake that the car industry has made. Mass residential property is a new market in China. The introduction of mortgages (only adjustable-rate mortgages) in 1998 kicked off the development of a mass residential market. The sales of new properties grew 24.5% per annum in volume between 1998 and 2003, and prices have been rising rapidly at the same time. Total sales of new properties are likely to reach 8% of GDP this year.
The property market appears to be entering the second phase. The stagnating sales and household savings deposits appear to suggest that the penetration of the high-income population is ending (see 'Property Market Turning', November 7, 2004). For the property market to continue rapid growth, it must cut prices to reach lower income populations.
However, property is a long-cycle business. The inventories or properties under construction are equal to 2.5–3 years’ supply (e.g., the inventories would reach one-third of GDP in market value by year-end). The property developers have already paid for land on the assumption that the prices would continue to rise. When the prices begin to fall, many developers would walk, leaving behind a wave of bad debts. Even though the property sector was much smaller ten years ago, it accounted for a big share of the bad debts from the last investment boom. One can still see many unfinished buildings from ten years ago in Hainan Island or Guangdong today.
The boom-burst cycles in manufacturing industries eventually lead to competitive export businesses that sustain China's growth. Such benefits are not available from the property sector. A property burst only leaves behind bad debts and does not offer any benefit. This is why, I believe, Chinese government should try hard to prevent overshooting in the property sector.
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