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China in 2025 and Implications for Automakers

Bill Russo Edward Tse Chee-Kiang Lim

Preface

As we know, China’s economy has been growing dramatically for more than two decades. China is now the world’s second largest economy. Recently, we see rising concerns over the impact of a deceleration in overall economic growth, especially on the automotive sector. China’s economic growth is likely to continue over the next decade, driven by a mix of continued (albeit more selective) fixed-asset investment and growth in consumption. Continued investment in infrastructure to support a more than 60% urbanized population is anticipated. Household consumption levels will rise as a result of the growth in the population of middle-class wage earners and overall rising incomes. A broad transformation is expected to continue and will present an environment that is characterized by a long term and sustained shift towards a middle-income, consumption-based economy. This trend would lead to a profoundly different economic landscape. We believe discontinuities in the political, social and economic landscape have the potential to reshape China dramatically in the next decade. While the outlook is positive, there will likely be discontinuities – some upward and some downward – along the way. We believe that the key to sustainable success for businesses in China will depend on their ability to anticipate those trends and challenges that are in the “blind spots” today - but which can create disruptive threats or discontinuous opportunities for those who are able to respond rapidly. In essence, an “early warning system” is needed which leverages unique insights that can be brought to bear on the question of how the market, the regulatory system, and business models may develop over the next decade in China. In this analysis, we will apply such a thought process to anticipate plausible scenarios for the China auto industry in 2025.

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China has gone through rapid urbanization over the past few decades, with urban population share rising from 17.9% in 1978 to 53.7% in 2013. City clusters such as Beijing-Tianjin, Shanghai-Yangtze River Delta and Guangzhou-Pearl River Delta are home to 18% of China’s population and generate 36% of the nation’s GDP. Cities are the main engines of China’s rapid economic growth in the past few decades. Nonetheless, the development is highly unbalanced with urbanization rates of 62% in the coastal regions, but only 44%-48% further inland.

The urbanization momentum will continue, on a size and scale never before experienced in history. By 2025, 65% of Chinese citizens will live in urban

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Urbanized world population centers. This will no doubt place significant stress on the environment as well as the urban transportation infrastructure, which is already struggling to keep up with the current urban population. While restrictions placed on car registrations have limited growth rates in the more mature coastal tier 1 and tier 2 cities, China’s automotive industry will continue to expand, albeit at a more sustainable rate, with a steady stream of first time purchasers from lower-tier cities joining the repeat buyers and upgraders of the more mature regions. Emergence of the less developed lower-tier regions will be the key driver to incremental demand for personal mobility.

On one hand, a more “binary” market will emerge with consumers in the more mature upper-tier cities continuing to prefer globally recognized car brands, while those from lower-tier cities will seek

Exhibit 1 China 2025 Scenarios: Urbanized World

Possible 2025 scenarios Implication to automakers � Emerging from China’s lower-tier region, a

Chinese automaker has become the first to sell 1M cars in overseas markets, and they are commonly called ‘the Chinese Hyundai”. Chinese OEMs are now competing in the EU and North America

� To secure long-term growth, automakers must strengthen offerings in the entry-level segment, in addition to offering newer products that cater to the emerging middle class

� Leverage China as the base to develop entry-level models for export to other developing markets

� Having successfully penetrated China’s lower-tier markets with cars engineered in China, automakers are selling “Engineered in China” cars in the global markets

� To expand the market, auto loan penetration reaches 50% in China and financing becomes a critical lever for growth, particularly with younger, budget-conscious buyers

� Deployment of an innovative business model for selling a full range of mobility and after-sales services


Today, China has 14 cities with more than 10 million residents. This number will likely double by 2025. As the home to many densely populated urban areas, China will require unique solutions for traffic congestion, energy consumption and pollution. The privately owned, energy-intensive and people-driven cars on the road today are not viable and sustainable solutions for future urban mobility.

By 2025, new urban mobility solutions will be comprised of a mixture of public transportation, non-motorized alternatives and energy-efficient personal transportation solutions. Innovations in technology, business models and regulation will come together to disrupt the automotive industry. We anticipate a number of discontinuities:

Innovative car use model In an effort to rebalance supply of transportation solutions with demand for mobility, we believe a car ownership model will gradually shift towards a “pay-per-use” service model, especially in the higher tier cities. The pace of this shift can be significantly accelerated with regulatory intervention forcing higher usage charges on those who choose to own vehicles.

New mobility solutions no-frills products and solutions from brands that deliver “the greatest bang for their RMB”. On the other hand, pockets of “new wealth” will also emerge in the lower tier cities, which will begin to mimic the buying patterns of more affluent consumers in the higher tier cities. This presents unique opportunities for both foreign and domestic manufacturers.

Domestic brands will remain more popular among lower-tier cities’ consumers as they penetrate the market with lower-priced cars that are “good enough” to meet their mobility needs. Chinese automakers could continue to serve this base by leveraging their lower-cost advantage and improving their product safety and quality performance. International OEMs must also seize the opportunity to develop competitive entry-level models and no-frills platforms tailored for the Chinese market, while subsequently leveraging such “Engineered in China” offerings to penetrate other developing markets.

China in 2025 and Implications for Automakers 4


By 2025, a pay-per-use model will emerge as a viable alternative for providing personal mobility in populous urban areas. On the one hand, the China government will continue to regulate new car registrations through tax or quota to limit the growth of private car ownership in large urban areas. On the other hand, escalating parking and traffic congestion charges will make private vehicle ownership less economical and therefore less attractive.

A technology-enabled intelligent model will supplant traditional car leasing and rental companies’ asset-heavy offline model. This will confer advantages and pave the way for internet-powered “mobility services” companies to emerge in the market. Moreover, peer-to-peer (P2P) car sharing will position platform companies at the center of the eco-system, connecting online and offline activities through advanced mobile technology. As the ownership-usage model evolves, OEMs will need to partner

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with digital players and service providers to offer innovative products in order to maintain their market shares.

Connected “smart” cars In large cities, driving is becoming an increasingly frustrating, time-consuming chore. At the same time, traffic accidents and congestion are by-products of human driving behavior and inadequate traffic and urban infrastructure planning. Smart, connected cars will rely on telecommunication and sensor technologies to respond to vehicles, objects and people while navigating, and communicating with its passengers through their on-board telematics system. A smart transportation system has the potential to eliminate accidents, increase the capacity of existing road infrastructure, collect and disseminate useful real-time traffic data, and at the same time facilitate new models of vehicle ownership, increase travel time predictability, and improve productivity and energy efficiency.

Exhibit 2 China 2025 Scenarios: New Mobility Solutions

Possible 2025 scenarios Implication to automakers � Chinese internet companies vertically integrate

car leasing services into their internet portals � Partner with innovators and

internet companies to deliver “urban mobility services” for different markets

� Alibaba successfully builds alliances with leading OEMs to develop synergies with the “Internet of Mobility”

� Tencent successfully acquires a recognized automotive brand



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Exhibit 3 China 2025 Scenarios: Connected “Smart” Cars

Possible 2025 scenarios Implication to automakers � Driven by policy in tier 1 and some tier 2 cities,

China has invested in building a smart transportation infrastructure and 300M “Smart Vehicles” are on the road

� Consider leveraging China as a base platform for smart car technology development for the global markets

� Just 17 years of age, Jasmine Wang summons her Xiaomi car via her mobile device, which arrives at her door step within minutes and delivers her to school, while allowing her to do her last minute revision for her college examination, Gaokao (高考), en-route

� Invest in disruptive technologies at the intersection of automotive and internet - leveraging both organic and in-organic business development � “TencentCar” competes with “Apple Car Play”

and “Android Auto” on user experience, network connectivity and localized content – and enjoys strong user acceptance

(EV) subsidies and qualify a wider range of fuel-efficient and environmental friendly technologies. These and other similar forthcoming policies are critical for China to fulfill its commitment to slow and then stop its emissions growth by 2030 under the recently concluded climate change agreement with the US.

City cars will adopt fuel-efficient and environmentally friendly technologies, such as lightweight composite components and electric powertrains. New generations of ultra-light weight personal urban mobility (PUM) devices will become popular – designed specifically for city-use to transport 1-2 persons and light cargo over short distances. OEMs will partner with non-traditional suppliers and utility companies to complete the eco-system.

According to China’s Ministry of Industry & Information Technology, as a strategic focus of the national development plan, the Chinese Government will provide up to 10B RMB in subsidies to catalyze the development of “smart mobility”.

Energy Saving & New Energy Vehicles China has become the world’s largest carbon emitter. Big cities suffer from pollution, often exceeding “hazardous” levels. By 2025, China will become the world’s largest oil importer, spending USD500B a year on crude oil imports, 66% of which will likely be from OPEC nations. Worsening pollution and energy security has compelled China to seriously invest in New Energy Vehicles (NEV) and related infrastructure development. The Government will continue electric vehicle



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Exhibit 4 China 2025 Scenarios: Energy Saving & New Energy Vehicles

Possible 2025 scenarios Implication to automakers � China’s investment in EV charging stations and

smart grid construction has created the complete eco-system for “Made in China” New Energy Vehicles, which are now being exported to the US and Europe

� Engage with Chinese partners (auto, government and infrastructure) to build the supporting ecosystem in order to make the EV technology value proposition accessible in the China market

� New generation of ultra-light weight personal urban mobility (PUM) devices are popular – designed specifically for city-use to transport 1-2 persons and light cargo over short distances

� All taxi and bus fleets in China are fully electrified, with foreign brands excluded from the approved vendor list

� Energy Saving and New Energy Vehicles achieve 25% share of a 40M unit market as traditional gasoline-powered cars are banned from densely populated cities

positional advantages, i.e., those which have been bestowed upon them by the government.

Starting in 2015, a new round of SOE reform will be led by the State-owned Assets Supervision and Administration Commission of the State Council (SASAC). These reforms will focus on diversifying ownership, adopting modern corporate governance, and establishing a state-owned asset management company. This will greatly impact the auto sector. As a result, state-owned automotive OEMs and suppliers will have the mandate to become more efficient and market-driven. Ultimately, consolidation should eliminate the weaker players. Several of the remaining local

Over the last several decades, China’s policies and industrial developments have typically been implemented via investments made with government-backed State-Owned Enterprises (SOEs). While many SOEs have shown good to strong profitability (at least on paper), their capabilities and entrepreneurial capacities vary a great deal. Many, especially those in government-protected sectors, derive their competitive advantages through mostly structural

Emergence of “reformed” SOEs alongside innovative new entrants



OEMs and suppliers will play an even more important role in the global automotive industry.

Meanwhile, we expect to see new entrants into the automotive ecosystem, especially innovative companies armed with disruptive technologies. It is entirely plausible that an Internet mobility services provider becomes a major player the automotive industry by initially offering a portal to provide “mobility services”.

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Exhibit 5 China 2025 Scenarios: Emergence of “Reformed” SOEs Alongside Innovative New Entrants

MNC players will need to adjust their strategies to address a competitive landscape that includes a new breed of new players and new suppliers who will be “mixed-equity enterprises” rather than wholly-state-owned companies, as well as nimble Internet mobility services suppliers who aim to create a new ecosystem of personal transportation services. Many of these services may be first incubated in China before being rolled-out to the rest of the world.

Possible 2025 scenarios Implication to automakers � Reformed, more efficient, SOEs who have

become “mixed equity enterprises” and innovative new entrants with preferred access to the 40M unit China market provide a platform for rapidly scaling up new transportation solutions for global deployment

� Re-define relationships with the reformed SOEs based on a deep understanding of who they are and what you would like to achieve, e.g. become strategic partners to jointly exploit overseas market leveraging China as a base

� 飞马 (Fei Ma, or Flying Horse) is the top selling luxury sedan globally for the past 5 years; fully designed and crafted by skilled artisans in China, it offers unparalleled but understated luxury with strong oriental themes and innovative technologies that have become the rage of the globally mobile elite around the world



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Conclusion

The discontinuities we have described are all very plausible and in fact, we believe many of them will emerge well before 2025 – the key question is whether traditional auto OEMs will first recognize the potential disruptive threats, and are then willing to seize the discontinuous opportunities that may ensue. Like Nokia and Motorola 10 years ago, auto OEMs may be facing an existential threat from new entrants from outside their traditional competitive sphere. Such competitors are anxious to seize on the Chinese consumer’s rapid acceptance and adoption of mobile technology and pervasive Internet connectivity services to deliver a new ecosystem for “mobile connected car services”.

Automotive OEMs have the complex challenge of addressing this potential for disruptive change, while simultaneously continuing to deliver better and more cost efficient products in the hyper-competitive China market. In addition, for many international OEMs, their joint venture partners who are today SOEs will most likely morph into something different over the next decade. Understanding the new agenda of these partners in their new form will be a critical factor in sustaining

the business relationship going forward. Furthermore, there is a high probability that the current joint venture policy for OEMs could be re-defined or even abolished. To what extent the international (and for that matter, the local) OEMs are ready to deal with such a change is a big question mark.

In summary, the ability to simultaneously address these challenges will separate the ultimate winners and losers in the next decade. The only thing that is certain is that the formula that has worked until now is no guarantee for future success.



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About the authors

Edward Tse is founder and CEO of Gao Feng Advisory Company. He built and ran the Greater China operations of two leading international management consulting firms for a period of 20 years. He has consulted to hundreds of companies – both headquartered in and outside of China – on all critical aspects of business in China and China for the world. He also consulted to the Chinese government on regional strategies, state-owned enterprise reform and Chinese companies going overseas. He is the author of over 150 articles and three books including the award-winning The China Strategy. His fourth book, China’s Disruptors, is coming out in mid-2015.

Bill Russo is Managing Director and the Automotive Practice leader at Gao Feng Advisory Company. His over 30 years of experience includes 15 years as an automotive executive, including 11 years of experience in China and Asia. He has worked with numerous multinational and local Chinese firms in the formulation and implementation of their global market and product strategies. While the Vice President of Chrysler North East Asia, he successfully negotiated agreements with partners and obtained required approvals from the China government to bring six new vehicle programs to the market in a three-year period, while concurrently establishing an infrastructure for local sourcing and sales distribution. Mr. Russo is a highly sought after opinion leader on the development of China’s automotive industry.

Chee-Kiang Lim is a Principal at Gao Feng Advisory Company. He has over 18 years of experience, including 10 years of consulting experience in strategy development and operational improvement for large multinational corporations. In addition to the automotive sector, he also has deep expertise in the oil & gas, mining and high-tech industries in China, Southeast Asia and Australia. He has previously worked in telecoms and high-tech start-ups in the Boston area and the Administrative Service of the Singapore Government.


Gao Feng Advisory Company (www.gaofengadv.com) is a pre-eminent strategy and management consulting firm with roots in China coupled with global vision, capabilities, and a broad resources network. We help our clients address and solve their toughest business and management issues -- issues that arise in the current fast-changing, complicated and ambiguous operating environment. We commit to putting our clients’ interest first and foremost. We are objective and we view our client engagements as long-term relationships rather than one-off projects. We not only help our clients “formulate” the solutions but also assist in implementation, often hand-in-hand. We believe in teaming and working together to add value and contribute to problem solving for our clients, from the most junior to the most senior. Our senior team is made up of seasoned consultants previously at leading management consulting firms and/or ex-top executives at large corporations. We believe this combination of management theory and operational experience would deliver the most benefit to our clients. Our name Gao Feng is taken from the Song Dynasty Chinese proverb Gao Feng Liang Jie. Gao Feng denotes noble character while Liang Jie refers to a sharp sense of integrity. We believe that this principle lies at the core of management consulting – a truly trustworthy partner who will help clients tackle their toughest issues.

For More Information:

Edward Tse Founder and CEO Gao Feng Advisory Company, Ltd. Email: [email protected] Bill Russo Managing Director Gao Feng Advisory Company, Ltd. Email: [email protected]

Chee-Kiang Lim Principal Gao Feng Advisory Company, Ltd. Email: [email protected]

Note: The above authors wish to thank Ms. Emily Wang for her efforts in researching and summarizing the findings of this analysis.