China Price Strategy May Backfire on OEM Automotive Industry
By Jack Lifton
23 Mar 2006 at 01:14 PM EST
DETROIT (ResourceInvestor.com) -- The international press has lately found the openly contentious nature of this year’s, traditional annual price negotiations between the major non-Chinese global iron ore mining companies and the large domestic Chinese steel producers to be newsworthy. This is because the negotiations have sent an alarm signal to the regulatory central planning bodies of China’s economy that, unlike their counterparts in most countries that have free market economies, have extensive power to directly intervene in the negotiations and make decisions that even “privately” owned and managed Chinese companies must obey from that point forward.
The China Chamber of Commerce of Metals Minerals & Chemicals Importers & Exporters (CCCMC) has much more than an advisory, analytical and existing regulation enforcing role in the Chinese state’s economic planning. The CCCMC exists to enforce, in its area of industrial oversight, the decisions of the Central Committee of the Communist Party of China with regard to long-term economic planning.
The China Iron & Steel Association (CISA), the steel industry’s trade group, has little or no power to disobey mandates from the CCCMC. The Chinese “regulatory agency” intervened in the negotiations because of the proposal by the mining companies that the benchmark ore price be raised by 20% this year after that same price was raised by 71% in 2005.
Last month, in February, the vice chairman of the CCCMC stated that any increase in the benchmark price would exacerbate the already shrinking profitability of the Chinese steel industry. The mining companies have replied that they must first and foremost look out for their own best economic interests and are not to blame for a lack of good long-term strategic planning by agencies of the Chinese central government. As of this rating the original Chinese negotiating “position” that no increases would be allowed has softened to one of no increases beyond 15%-20%!
I believe that this seemingly basic issue of allowing the market pricing of a commodity natural resource to be a factor in long-term strategic planning has exposed a flaw in the “China price” strategy that is, for example, at the core of the programs in the remaining OEM American owned automobile industry to cut down and hold down its costs of purchased parts. That part of the Chinese steel industry, which uses iron ore as its principal raw material, if it has no other way to reduce costs proportionately can have only one natural reaction to increased costs for raw materials. It will and must raise its own steel prices if it is to maintain the cash flow necessary to retire the huge debt it has occurred to expand, consolidate and modernize. The three obvious factors driving this natural re-pricing, at least in American dollar terms, are:
1.
Rising global commodity iron ore costs due to demand exceeding supply;
2.
Sharply increasing domestic Chinese demand, particularly for the high quality steel used to make cars (just now being produced in limited quantities) and;
3.
An improving exchange rate of the Chinese currency versus the American dollar.
Even in the unlikely event that one of these factors (global iron ore prices) were to become stabile, or, even more unlikely, move down somewhat, it is very unlikely that either of the other two factors will decline in the near or medium term, because of the steady and burgeoning growth of the Chinese economy. It has been predicted that the Chinese yuan, which at this writing is pegged at 8.028 to the U.S. dollar could, if some present trends continue, including pressure to revalue immediately by the American political establishment, by the end of 2006, be at 7.63 to the U.S. dollar. This change alone would move the Chinese steel price up by as much as 5%.
Although the American government also has regulatory agencies that oversee the obedience to international law, treaties and trade agreements by American companies it rarely attempts to intervene beforehand in the commodity markets, because American governmental regulation of its free market economy tends to be reactive rather than proactive like that in centrally planned economies. For reasons of competitiveness American corporations also delegate much less power to trade associations than is given to similar organizations in centrally planned economies. American corporations are pretty much free to make their own mistakes and to suffer their consequences.
How would or will this global iron ore pricing issue affect the major remaining American owned OEM automotive companies?
To look at one possibility, the effect of this issue on the American General Motors Corporation [NYSE:GM], we must realize that it was only three years ago, in 2003, GM had just a handful of (direct) employees at its global purchasing group in the United States who were fluent in Chinese. GM did, however, already then have a large number of Chinese nationals employed, at its operations in China, who were involved with sourcing parts in China for the cars produced there by GM with its joint venture Chinese partners. In addition some of GM’s tier one (i.e., direct) suppliers of production parts and assemblies had Chinese operations most of which were, due to Chinese government restrictions on foreign ownership, joint ventures with “equivalent” Chinese companies some private and some state owned.
GM’s current global purchasing strategy, like that of Wall Street investment analysts, seems to have become enamored of the low costs generated by Wal-Mart’s Chinese purchasing strategy for its broad range of consumer items, the production of which is labor intensive, such as hand tools, basic power tools for home use, low end appliances, textiles, clothing, shoes and similar items.
It is frequently said that Wal-Mart alone accounts for 10% of the total of U.S. yearly imports from China in U.S. dollar terms. What is not said is that these consumer items do not require that the Chinese suppliers meet and maintain the fairly rigid and generally very high quality standards that the OEM automotive industry has developed over a very long period of time and that it technically and officially requires that its suppliers have in place before they can be approved as a suppliers of production parts!
These American OEM automotive industry standards are denominated as QS900X (production parts manufacturing) and ISO1400X (Non production parts and operations such as environmental control), where X is an integer denoting the current version of the standard. The European standard for production parts manufacturing is currently TS16949. The OEM automotive world is moving towards adopting the TS standards as universal.
In 2003, GM U.S. did a survey and determined that less than 50 Chinese production parts suppliers met its QS and ISO standards then in place. It turned out, however, that the survey was hopelessly flawed by misinterpreted internal communications, language difficulties and self-interest on the part of GM’s China operations in controlling the access of the Chinese suppliers that they used themselves to the parent company in Detroit. Upon discovering, addressing and resolving these internal problems, GM was surprised but delighted to learn that thousands of Chinese companies either met the quality standards or could be mentored by GM or appropriately similar American and European Tier One suppliers to meet the standards reasonably quickly.
GM global purchasing then went ‘gung ho’ and adopted a “China Price” strategy, based on the Wal-Mart model, for cutting the costs of purchased parts by establishing a “China Price” as the target that all vendors were required to meet either by price cutting, or as GM purchasing actually suggested, by moving their operations to China!
GM U.S.’s purchasing group set the actual particular “China Price” itself for a part or assembly. This was done by first selecting one or more Chinese approved or qualifiable suppliers and then giving them the opportunity to bid on a part for which the price was being established. Note that the de-acquisition of Delphi (and, for Ford [NYSE:F], of Visteon) at the end of the twentieth century means that GM actually makes very few component parts itself. GM’s Tier One suppliers balked at sometimes being “required” to give all of their, often proprietary, design and manufacturing process information to Chinese suppliers for “pricing” purposes. It is not at all clear that even when given such information was up-to-date or entirely accurate.
All of this “China Price” strategy has been put together only since 2003. Previous to the implementation of the “China Price” strategy all of GM’s, as well as their competitor’s, suppliers had been heavily impacted negatively, financially, by a prior disastrous-to-them cost cutting strategy. In any case at the end of 2005 GM purchasing, being unable to meet internal cost reduction targets for purchased parts in any other way, set a target for itself of sourcing at least 30% of its total buy of production parts in China by the end of 2006!
China is now the world’s largest producer of steel; it manufactures fully a third of all the steel made though, it must be noted, nowhere yet near a third of the high quality steel used to manufacture car bodies. China’s steel production has grown by 20% per year for the last five years, the most phenomenal increase by any nation’s steel industry in history.
The problem that the Chinese steel industry is having with the negotiations for long-term iron ore supplies with the likes of BHP [NYSE:BHP], Vale [NYSE:RIO] and Rio Tinto [NYSE:RTP] in Australia, India and Brazil is that China’s is the very steel industry that is pushing demand relentlessly, so that in order for the ore producers to increase supply they must raise large amounts of capital to open new mines, reopen old, previously marginal, mines and explore for new sources of ore as well as do research on more efficient mining and concentrating processes.
All of these projects cost a lot of money, but the mining industry has had the lowest return on investment capital of any major industry for the last 50 years. Therefore, investors are reluctant to go into long-term mining projects. So the only sure way to raise the capital is to raise prices.
Mining companies got a 71% increase in the price of iron ore just in the year 2005 and the Chinese, who took 43% of the global ore trade in 2005 are justifiably balking at a further 20% increase being asked for this year. But China is stuck. It cannot replace the imported ore with domestic production, and it cannot slow down its production of steel, because it must also generate huge amounts of capital to pay off the costs of building up its steel industry so fast. Steel making costs will go up and margins will go down in the face of well managed global competitors like Mittal Steel [NYSE:MT], which gets at least half of its ore from its own mines.
Conclusion
The OEM American automobile industry in general and GM in particular seem now to be betting that, at worst, Chinese steel prices will, even if they go up, simply go up in a manageable and predictable way, perhaps only in lock step with American domestic inflation. This assumes, of course, that not only will the factors discussed above have no effect on price, but also that the American dollar will remain as the world’s benchmark currency.
I believe that neither assumption is accurate and that therefore a purchasing strategy that is becoming more and more dependent on outsourcing to China for the purpose of maintaining low prices may well backfire and not be effective in reducing the noncompetitive pricing of cars assembled in the U.S. by American owned OEM automotive companies.
I call the GM purchasing agenda a “mostly-one-low-labor-cost-country strategy.” I think it is an example of a short sighted approach, that fails in the light of a broader economic perspective but I want to add that I don’t think that either the Ford Motor Company or The Chrysler division of DCX or the overwhelming majority of their tier one suppliers has any better approach to the problem. To paraphrase James Carville: “It’s the global economy, st...d!”
China Price Strategy May Backfire on OEM Automotive Industry
By Jack Lifton
23 Mar 2006 at 01:14 PM EST
DETROIT (ResourceInvestor.com) -- The international press has lately found the openly contentious nature of this year’s, traditional annual price negotiations between the major non-Chinese global iron ore mining companies and the large domestic Chinese steel producers to be newsworthy. This is because the negotiations have sent an alarm signal to the regulatory central planning bodies of China’s economy that, unlike their counterparts in most countries that have free market economies, have extensive power to directly intervene in the negotiations and make decisions that even “privately” owned and managed Chinese companies must obey from that point forward.
The China Chamber of Commerce of Metals Minerals & Chemicals Importers & Exporters (CCCMC) has much more than an advisory, analytical and existing regulation enforcing role in the Chinese state’s economic planning. The CCCMC exists to enforce, in its area of industrial oversight, the decisions of the Central Committee of the Communist Party of China with regard to long-term economic planning.
The China Iron & Steel Association (CISA), the steel industry’s trade group, has little or no power to disobey mandates from the CCCMC. The Chinese “regulatory agency” intervened in the negotiations because of the proposal by the mining companies that the benchmark ore price be raised by 20% this year after that same price was raised by 71% in 2005.
Last month, in February, the vice chairman of the CCCMC stated that any increase in the benchmark price would exacerbate the already shrinking profitability of the Chinese steel industry. The mining companies have replied that they must first and foremost look out for their own best economic interests and are not to blame for a lack of good long-term strategic planning by agencies of the Chinese central government. As of this rating the original Chinese negotiating “position” that no increases would be allowed has softened to one of no increases beyond 15%-20%!
I believe that this seemingly basic issue of allowing the market pricing of a commodity natural resource to be a factor in long-term strategic planning has exposed a flaw in the “China price” strategy that is, for example, at the core of the programs in the remaining OEM American owned automobile industry to cut down and hold down its costs of purchased parts. That part of the Chinese steel industry, which uses iron ore as its principal raw material, if it has no other way to reduce costs proportionately can have only one natural reaction to increased costs for raw materials. It will and must raise its own steel prices if it is to maintain the cash flow necessary to retire the huge debt it has occurred to expand, consolidate and modernize. The three obvious factors driving this natural re-pricing, at least in American dollar terms, are:
1.
Rising global commodity iron ore costs due to demand exceeding supply;
2.
Sharply increasing domestic Chinese demand, particularly for the high quality steel used to make cars (just now being produced in limited quantities) and;
3.
An improving exchange rate of the Chinese currency versus the American dollar.
Even in the unlikely event that one of these factors (global iron ore prices) were to become stabile, or, even more unlikely, move down somewhat, it is very unlikely that either of the other two factors will decline in the near or medium term, because of the steady and burgeoning growth of the Chinese economy. It has been predicted that the Chinese yuan, which at this writing is pegged at 8.028 to the U.S. dollar could, if some present trends continue, including pressure to revalue immediately by the American political establishment, by the end of 2006, be at 7.63 to the U.S. dollar. This change alone would move the Chinese steel price up by as much as 5%.
Although the American government also has regulatory agencies that oversee the obedience to international law, treaties and trade agreements by American companies it rarely attempts to intervene beforehand in the commodity markets, because American governmental regulation of its free market economy tends to be reactive rather than proactive like that in centrally planned economies. For reasons of competitiveness American corporations also delegate much less power to trade associations than is given to similar organizations in centrally planned economies. American corporations are pretty much free to make their own mistakes and to suffer their consequences.
How would or will this global iron ore pricing issue affect the major remaining American owned OEM automotive companies?
To look at one possibility, the effect of this issue on the American General Motors Corporation [NYSE:GM], we must realize that it was only three years ago, in 2003, GM had just a handful of (direct) employees at its global purchasing group in the United States who were fluent in Chinese. GM did, however, already then have a large number of Chinese nationals employed, at its operations in China, who were involved with sourcing parts in China for the cars produced there by GM with its joint venture Chinese partners. In addition some of GM’s tier one (i.e., direct) suppliers of production parts and assemblies had Chinese operations most of which were, due to Chinese government restrictions on foreign ownership, joint ventures with “equivalent” Chinese companies some private and some state owned.
GM’s current global purchasing strategy, like that of Wall Street investment analysts, seems to have become enamored of the low costs generated by Wal-Mart’s Chinese purchasing strategy for its broad range of consumer items, the production of which is labor intensive, such as hand tools, basic power tools for home use, low end appliances, textiles, clothing, shoes and similar items.
It is frequently said that Wal-Mart alone accounts for 10% of the total of U.S. yearly imports from China in U.S. dollar terms. What is not said is that these consumer items do not require that the Chinese suppliers meet and maintain the fairly rigid and generally very high quality standards that the OEM automotive industry has developed over a very long period of time and that it technically and officially requires that its suppliers have in place before they can be approved as a suppliers of production parts!
These American OEM automotive industry standards are denominated as QS900X (production parts manufacturing) and ISO1400X (Non production parts and operations such as environmental control), where X is an integer denoting the current version of the standard. The European standard for production parts manufacturing is currently TS16949. The OEM automotive world is moving towards adopting the TS standards as universal.
In 2003, GM U.S. did a survey and determined that less than 50 Chinese production parts suppliers met its QS and ISO standards then in place. It turned out, however, that the survey was hopelessly flawed by misinterpreted internal communications, language difficulties and self-interest on the part of GM’s China operations in controlling the access of the Chinese suppliers that they used themselves to the parent company in Detroit. Upon discovering, addressing and resolving these internal problems, GM was surprised but delighted to learn that thousands of Chinese companies either met the quality standards or could be mentored by GM or appropriately similar American and European Tier One suppliers to meet the standards reasonably quickly.
GM global purchasing then went ‘gung ho’ and adopted a “China Price” strategy, based on the Wal-Mart model, for cutting the costs of purchased parts by establishing a “China Price” as the target that all vendors were required to meet either by price cutting, or as GM purchasing actually suggested, by moving their operations to China!
GM U.S.’s purchasing group set the actual particular “China Price” itself for a part or assembly. This was done by first selecting one or more Chinese approved or qualifiable suppliers and then giving them the opportunity to bid on a part for which the price was being established. Note that the de-acquisition of Delphi (and, for Ford [NYSE:F], of Visteon) at the end of the twentieth century means that GM actually makes very few component parts itself. GM’s Tier One suppliers balked at sometimes being “required” to give all of their, often proprietary, design and manufacturing process information to Chinese suppliers for “pricing” purposes. It is not at all clear that even when given such information was up-to-date or entirely accurate.
All of this “China Price” strategy has been put together only since 2003. Previous to the implementation of the “China Price” strategy all of GM’s, as well as their competitor’s, suppliers had been heavily impacted negatively, financially, by a prior disastrous-to-them cost cutting strategy. In any case at the end of 2005 GM purchasing, being unable to meet internal cost reduction targets for purchased parts in any other way, set a target for itself of sourcing at least 30% of its total buy of production parts in China by the end of 2006!
China is now the world’s largest producer of steel; it manufactures fully a third of all the steel made though, it must be noted, nowhere yet near a third of the high quality steel used to manufacture car bodies. China’s steel production has grown by 20% per year for the last five years, the most phenomenal increase by any nation’s steel industry in history.
The problem that the Chinese steel industry is having with the negotiations for long-term iron ore supplies with the likes of BHP [NYSE:BHP], Vale [NYSE:RIO] and Rio Tinto [NYSE:RTP] in Australia, India and Brazil is that China’s is the very steel industry that is pushing demand relentlessly, so that in order for the ore producers to increase supply they must raise large amounts of capital to open new mines, reopen old, previously marginal, mines and explore for new sources of ore as well as do research on more efficient mining and concentrating processes.
All of these projects cost a lot of money, but the mining industry has had the lowest return on investment capital of any major industry for the last 50 years. Therefore, investors are reluctant to go into long-term mining projects. So the only sure way to raise the capital is to raise prices.
Mining companies got a 71% increase in the price of iron ore just in the year 2005 and the Chinese, who took 43% of the global ore trade in 2005 are justifiably balking at a further 20% increase being asked for this year. But China is stuck. It cannot replace the imported ore with domestic production, and it cannot slow down its production of steel, because it must also generate huge amounts of capital to pay off the costs of building up its steel industry so fast. Steel making costs will go up and margins will go down in the face of well managed global competitors like Mittal Steel [NYSE:MT], which gets at least half of its ore from its own mines.
Conclusion
The OEM American automobile industry in general and GM in particular seem now to be betting that, at worst, Chinese steel prices will, even if they go up, simply go up in a manageable and predictable way, perhaps only in lock step with American domestic inflation. This assumes, of course, that not only will the factors discussed above have no effect on price, but also that the American dollar will remain as the world’s benchmark currency.
I believe that neither assumption is accurate and that therefore a purchasing strategy that is becoming more and more dependent on outsourcing to China for the purpose of maintaining low prices may well backfire and not be effective in reducing the noncompetitive pricing of cars assembled in the U.S. by American owned OEM automotive companies.
I call the GM purchasing agenda a “mostly-one-low-labor-cost-country strategy.” I think it is an example of a short sighted approach, that fails in the light of a broader economic perspective but I want to add that I don’t think that either the Ford Motor Company or The Chrysler division of DCX or the overwhelming majority of their tier one suppliers has any better approach to the problem. To paraphrase James Carville: “It’s the global economy, st...d!”
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