University of Toronto 4 Capability Building in China’s ...econweb2012.econ.kuleuven.ac.be/.../CV/bvb06rotman... · Original equipment manufacturers (OEMs) design the vehicles and

Capability Building in China’s Auto Supply Chains

4-1

4

Loren Brandt & Johannes Van Biesebroeck University of Toronto

ABSTRACT

E REPORT on plant visits and data collection carried out in China and present our initial preliminary findings. Eight assembly

plants with their respective seat, exhaust and brake suppliers were visited in 2006. Two ECU (engine control unit) suppliers were also interviewed. Where possible, we compare our findings with the situation in China in 2003 and with current best practice worldwide. Information collected pertains to productivity, quality, structure and evolution of the supply chain, engineering capabilities, and relationships with other firms. The outline of this preliminary report is as follows. First, we present our main findings. Second, we give some background information about our ongoing global supplier survey and the automobile industry. Third, we examine four key factors that are driving changes in China’s auto sector. We present both aggregate data and detailed observations from our plant visits that formed the basis for our preliminary conclusions.1 Fourth, we discuss some of the implications of these developments in China for auto-parts suppliers in Canada.

W

BRANDT & VAN BIESEBROECK

4-2

MAIN FINDINGS

N 2006, China produced more than 7 million vehicles, including commercial and passenger vehicles. Out of this, more than half were

passenger vehicles, making China the third-largest manufacturer of total vehicles and the seventh-largest in passenger vehicles. China now makes more passenger cars than Canada. China’s rise in the rankings of auto-producing countries is largely a product of growth since 2000, during which time the number of vehicles produced increased more than 300 percent. While China has become a leading exporter in a large number of manufacturing sectors, its total exports of automobile components are limited and its exports of final vehicles remain negligible.2 This seems particularly puzzling as the automobile industry is the largest traded sector in the rest of the world — both final and intermediate goods — and the assembly model (final vehicles assembled from parts that can be made anywhere) seems particularly suited to the comparative advantage of the Chinese. We would expect that China could easily expand in this industry by focusing on low-tech intermediate inputs and/or labour-intensive assembly. For example, a similar “assembly” model in the consumer electronics industry has made China the production hub of the world. So the question we are asking is, “Why are cars different?” The largest difference between an automobile and most electronics products is that the automobile is an “integrative design.” The defining feature of car design is that all components have to work together; changing one component often has implications for many others. For example, putting wider tires on a vehicle will often require different brakes and modifications to the suspension system. However, in a finely tuned modern car, it will generally also require changes in the wheel wells and the space for the spare tire in the trunk, and this has ripple effects for the entire chassis and body panels. Given that the interior has to be fitted exactly to the body, changes are likely there as well, and so on. Clearly, a minor change such as a different size of tire will not be made lightly. This insight has a number of implications. First, the supply chain in the industry has taken on a tiered format. Original equipment manufacturers (OEMs) design the vehicles and are involved in most of the engineering work. For the important modules in the vehicle (braking system, wiring harness, interior), they will select a first-tier supplier that will work with them to develop the module and coordinate design, production and logistics to the assembly plant. In turn, these first-tier suppliers will select second-tier suppliers, which will be in charge of smaller parts, and so on. Given the previously described interrelatedness of all the parts, it is no surprise that the OEM wants to

I

CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

4-3

have some say in the firms selected further upstream and that activities at each level in the supply chain are coordinated very intensely with activities at the level above and below. Second, the integrative design makes it much harder to separate the design and development functions from manufacturing. While some simple parts can simply be “made according to (blue) print” (MTP), this is much harder for complicated modules. Moreover, once a design is set in place and some parts are outsourced to low-tech and low-cost producers, for example, small domestic firms in China, nothing can be changed anymore in the vehicle. Given the wide-ranging model proliferation we are witnessing in the industry, this makes it hard to market and sell a vehicle. The marketing and sales division will clearly want a vehicle made to suit specific local tastes, but the challenges this poses for manufacturing are much greater than, for example, in the electronics industry. As a result, firm strategy has to be integrated across design, manufacturing and marketing. From our visits, we witnessed three (somewhat mutually exclusive) strategies for foreign multinationals to serve and be active in the Chinese market:

a. Integration of local production into the global supply chain of the company. An existing vehicle, designed for one of the major markets (North America, Europe and Japan) is selected for sale in China. To be competitive, it will be manufactured locally, saving labour and shipping costs. However, all design work is left intact and local suppliers will all “work to print.” In addition, more sophisticated intermediate inputs with more demanding quality requirements or possibly proprietary technology will be imported, using the same firm that is supplying the part to the assembly plant in the home country. This is certainly a preferred strategy if only small volumes are produced/sold. Rising volumes make this less desirable as costs are higher than when more local production is employed. The Chinese decision to introduce local content requirements for vehicles to count as locally assembled and not incur the higher tariff rates also makes this strategy more tenuous. The extreme model proliferation witnessed in mature markets (North America, Europe and Japan) could eventually increase the popularity of this strategy, but only for models at the upper end of the market.

b. Cautious localization. The Japanese and Korean producers seem to favour this approach. Vehicles are produced locally in China in large volumes but are still designed overseas. Most first-tier suppliers are joint ventures (JVs) between a local Chinese firm and a foreign partner that is responsible for manufacture and often the design of the part overseas. Some modules are even supplied by


4-4

wholly owned foreign subsidiaries (WOS) that are allowed in China for parts but not for final assembly. The OEM has to give explicit approval to use domestic firms, which tend to have a large cost advantage, even as second- or third-tier suppliers. (As a result, a majority of second-tier suppliers also tend to be either JVs or WOS.) This central organization facilitates achieving a high-quality product but raises costs since parts cannot be changed to facilitate local manufacturability. It is also more difficult to introduce products specifically aimed at the local market. While average income levels in the Chinese economy are rising rapidly, greater car ownership penetration results in relatively less wealthy people purchasing ever more vehicles. The high costs associated with the cautious localization strategy force these firms to pursue the upper segment of the market, which is becoming relatively less important. Firms following this strategy also aim at avoiding competition with the generally low-quality/low-cost domestic firms. One potential benefit of this strategy, however, is that it may enable OEMs to more easily tap into lower-cost sources for parts and components for the identical vehicle being assembled elsewhere.

c. Aggressive localization. A select number of joint ventures with European and American firms are taking this approach. Both the OEM and the first-tier suppliers set up design and engineering centres in China. Parts, modules and eventually full vehicles will be redesigned to better suit the taste of local consumers. An important advantage of this approach is that modules can also be redesigned to be compatible with the manufacturing capabilities of the domestic firms and meet local regulatory, i.e., safety and environmental, requirements. In this way, larger fixed costs are incurred in terms of design and engineering, but variable costs fall as domestic firms can be relied on more intensely (thus saving labour costs) and production processes can be chosen to better fit the local comparative advantage or even just the local capabilities. As a result, a vehicle can be produced at lower cost to compete directly with the cheaper domestic offering. The challenge is to find components where this localization is feasible and cost-effective, while at the same time making sure quality and fit are not compromised so that the brand is not cheapened.3

Competition and cooperation with the leading domestic firms — especially Chery, Geely and SAIC (Shanghai Automotive Industrial Corporation) — should also not be ignored. In terms of production, these firms would fall in category (c), aggressive localization. However, they are even more aggressive, sourcing virtually everything locally from joint ventures, wholly owned foreign suppliers and rapidly improving domestic firms. In an important way, they are piggybacking


4-5

on the domestic supply chain that has emerged around the joint-venture car assemblers but are simultaneously providing some first-tier suppliers with important “learning” opportunities. Currently, these local firms contract out much of the design work (and even some of the engineering and testing) on their vehicles and they rely very much on a well-developed supply chain or the expertise of either their foreign or domestic partners. The “integrative design” of the car highlights the fact that these firms will have to master design and development capabilities to be independently successful. We want to stress that only a few multinationals have chosen the third approach thus far, but this model could prove very disruptive for manufacturing in the more developed countries such as Canada. Moreover, intense competition in the domestic Chinese market and falling prices may be accelerating the process of local capability building. One major international OEM described a five-year plan to lower its production costs in China by 40 percent by 2010. In many industries, Canadian firms focus on the high-value-added segments in the value chain, which fits well with the highly skilled workforce. However, this is not compatible with the aggressive localization strategy that we observe unfolding in China. If the objective is to get parts and components not only manufactured but also designed locally, it is unclear what role will be left for Canadian workers in Canada. In an integrative design, it is often claimed that there are real benefits to having the designers and engineers in close proximity to the manufacturing facilities. If this model is pushed further, the Chinese industry will come to resemble the Canadian industry more and more. Chinese exports of final vehicles to Canada, expected in the not too distant future, could then be extremely disruptive to the Canadian industry. How the relationship between the multinationals and their joint-venture partners develops also remains to be worked out. Geely is planning to independently start exporting vehicles to North America in 2007–2008. Recently, DaimlerChrysler paired with Chery, which had started to build up its own dealer network in the United States, to manufacture and export compact cars to North America. On the other hand, SAIC — the joint-venture partner of General Motors and Volkswagen in Shanghai — has announced its intentions to start exporting and competing with its joint-venture partners in their home markets. A new JV involving Honda in Guangzhou is already exporting small compact cars (Fit/Jazz) to Europe.


4-6

BACKGROUND ON THE PROJECT

UR RESEARCH IN CHINA is part of the global automotive supplier benchmarking study of the International Motor Vehicle Program

(IMVP), which aims to compare and contrast practices, capabilities and performance of automobile suppliers around the world. The international assessment, focusing on seats, exhaust systems and brakes, will cover plants in China, South Korea, Japan, Europe and North America. We have already collected data in China and Japan (see Appendix for description of the data gathering effort to date in China). We are now collecting data in North America and Western Europe. The automotive industry is widely recognized as one of the economic pillars of the economy, both in North America and Western Europe. But globalization of production is rapidly reshaping the industry and the future competitiveness of these traditional manufacturing areas in the auto sector is questioned regularly. In a recent survey of the members of the Canadian Auto Parts Association, two thirds of respondents had been asked by major customers to initiate or expand activities in new geographic markets. This is just one of the many instances signalling the pressure that firms are under to offshore component purchases and production, especially to Asia. Two decades ago, when the emergence of Japanese automakers was raising equivalent questions, IMVP led the “Lean Manufacturing” revolution through its detailed international benchmarking work on automotive assembly plants. Nowadays, as suppliers grow in impact on and responsibility for the development of products and processes, the emphasis of the automotive industry is evolving toward the supply chain. Lead suppliers are global companies that increasingly have to deploy operations around the world. This has become particularly salient with the emergence of Asia, especially China, as a hub for automotive production. Yet there is a lack of understanding of the types of manufacturing strategies that firms are pursuing and their relative successes. This project aims to provide the first comprehensive assessment of suppliers around the world, looking at practices and capabilities as well as quality and productivity outcomes. Because of the complexity and challenges associated with this project, the strategy is to have a systematic and focused approach to the study:

• The study will make a detailed evaluation of equivalent units and comparable plant metrics in the various regions of the world rather than assessing a variety of suppliers, using financial indicators. This will allow careful comparisons among plants.

• The project will look at particular modules in the vehicle, focusing on seats, exhaust systems and brakes.

O


4-7

• The initial stages of the project will cover seven countries — China, Japan, Spain, Portugal, South Korea, the United States and Canada. Other nations can be considered in the future.

There are four questions that we want to answer:

• What is the productivity and quality gap among automotive component firms producing car seats and exhaust systems across regions?

• How are technological and engineering capabilities shared between firms internationally and domestically? This assessment will look at seats, exhaust systems and brake systems.

• How deep are the domestic supply chains and how quickly are they developing over time, especially in regions emerging as new players in the industry?

• Is the historical comparative advantage in the automotive industry in the United States, Western Europe and Japan sustainable in a global industry, especially in comparison with low-wage countries — especially China, but also South Korea?

To accomplish these objectives, we have developed a consistent measurement framework, including survey instruments to be completed during plant visits in each of the countries. The assessment proceeds in two steps:

• First, several OEM plants are chosen in a given region. These are interviewed to generically characterize their overall working conditions as well as their make-or-buy practices and to inquire about their supplier performance as well as collaboration work.

• Second, suppliers for car seats, exhausts and brakes for each focal OEM plant are also interviewed. This interview includes inquiries regarding the character of manufacturing practices, including specifics of plant organization, output and quality. There were also inquiries about evolving engineering capabilities; the relationship with OEMs, suppliers and other relevant players in the industry; as well as make-or-buy practices.

We have already collected data in China and Japan. Because of delays in obtaining access to firms in South Korea and North America, this work is now planned for 2008. Early results should be available by mid-2007. All data will be kept confidential and any comparisons are made against means of various firms or stylized examples to prevent any identification of underlying data.


4-8

WHAT DRIVES CHANGE IN CHINA’S AUTO SECTOR

HERE ARE FOUR KEY FACTORS driving change in China; these include the following:

• Intensified competition in the final goods market • Cost pressures through the supply chain similar to those in the West • Quality convergence with the West • Enhanced incentives for localization of research and development

(R&D) and product development

We examine each in turn.

INTENSIFIED COMPETITION IN THE FINAL GOODS MARKET

Since 2000, China’s motor vehicle sector has been the fastest growing motor vehicle sector in the world. Table 1 provides information on motor vehicle production for those countries that were producing more than one million vehicles in 2006 along with their production volume in 2000. Figure 1 shows the share of world motor vehicle production by country/region. Motor vehicles here include both passenger cars and commercial vehicles such as trucks and buses. In 2000, China was producing slightly more than two million vehicles per year and was the eighth-largest producer in volume terms. By 2006, China had catapulted to become the fourth-largest producer in the world, with total volume of 7.19 million units. (Preliminary figures for 2006 put total vehicle production over 7 million units.) China trailed only Japan (at 11.4 million units) and the United States (at 11.3 million units).4 Between 2000 and 2005, production in China’s motor vehicle sector grew 181.3 percent. By comparison, production declined in both the United States and Canada, while growing only modestly in Japan, Germany and France.

T


4-9

TABLE 1

COUNTRIES PRODUCING MORE THAN ONE MILLION VEHICLES PER YEAR

2000 2005 % Change

United States 12 770 714 12 018 043 –5.9%

Japan 10 144 847 10 799 659 6.5%

Germany 5 526 615 5 757 710 4.2%

China 2 008 500 5 648 972 181.3%

South Korea 2 858 378 3 699 350 29.4%

France 3 351 929 3 547 839 5.8%

Spain 3 032 874 2 753 856 –9.2%

Canada 2 961 636 2 664 749 –10.0%

Brazil 1 671 093 2 458 469 47.1%

United Kingdom 1 813 739 1 806 359 –0.4%

Mexico 1 922 889 1 691 878 –12.0%

India 866 863 1 553 194 79.2%

Russia 1 202 589 1 351 194 12.4%

Thailand 458 415 1 097 300 139.4%

Italy 1 738 315 1 038 352 –40.3%

Iran N/A 1 005 650 N/A


4-10

Europe, 30.7%

USA, 17.7%

Japan, 15.9%

China, 8.3%

Canada, 3.9%

Other, 23.3%

FIGURE 1

SHARE OF WORLD MOTOR VEHICLE PRODUCTION

Passenger cars represent a growing segment of China’s motor vehicle sector. In Figure 2, we break down total vehicle production into cars, buses and trucks for the period 1995–2005.5 Car production increased from 0.325 million units in 1995, or slightly less than a quarter of total vehicles, to 2.76 million in 2005, or nearly one half. (The preliminary figure for 2006 is 3.5 million units). Note the acceleration in the rate of growth beginning in 2000, most of which has gone to accommodate the domestic market. In 2005, exports of passenger cars were only 31 125.


4-11

0%

20%

40%

60%

80%

100%

1995 1997 1999 2001 2003 2005

Passenger

Buses

Trucks

0%

20%

40%

60%

80%

100%

1995 1997 1999 2001 2003 2005

Passenger

Buses

Trucks

FIGURE 2

BREAKDOWN OF MOTOR VEHICLE PRODUCTION

There are a number of important factors that help explain these trends. Especially important have been China’s entry into the World Trade Organization (WTO) and a combination of entry and expansion in the domestic industry. Tariffs on final vehicles as well as parts and components have fallen significantly since the late 1990s. For vehicles with engines smaller than 3 litres, representing the bulk of the domestic market, tariffs have been reduced from 80 percent before WTO accession to 25 percent by July 2006. (See Figure 3.) For parts and components, tariffs have fallen from an average of 25 percent to 10 percent over the same period. The reduction in tariff barriers has been complemented by significant entry and expansion by OEMs, especially multinationals, and more recently 100-percent-owned Chinese firms, which increased the level of competition in the industry significantly.


4-12

FIGURE 3

VEHICLE TARIFF RATES

0

20

40

60

80

100

120

1998

2000

2001

2002

2003

2004

2005

2006

.1.1

2006

.7.1

Year

Tarif

f Rat

e (P

erce

nt)

Less than 3L3L and up

0

20

40

60

80

100

120

1998

2000

2001

2002

2003

2004

2005

2006

.1.1

2006

.7.1

Year

Tarif

f Rat

e (P

erce

nt)

Less than 3L3L and up

In 2000, estimated production capacity for passenger cars was slightly less than a million units. By 2006, this had increased to 4.44 million units, with capacity for an additional 1.77 million units coming online in the same year.6 Entry by such established firms as Hyundai and Toyota plus a host of 100-percent domestic car manufacturers like Chery, Great Wall and Haima, and new investment by existing players helped to change significantly the complexion and dynamics of the Chinese auto sector. In 2000, two joint ventures dominated the market: one involved Shanghai Automotive Industrial Corporation (SAIC) and Volkswagen (VW) in Shanghai; the other was between First Auto Works (FAW) and VW-Audi in Changchun, Jilin. Combined, they produced 55 percent of all cars in China. Adding in Tianjin Xiali, which licensed technology from Japan, the top three manufacturers captured more than two thirds of the domestic market for passenger cars.


4-13

By 2005, Shanghai GM, a joint venture between GM and SAIC, was the largest producer, manufacturing 0.328 million cars, but it held only 10.5 percent of the domestic market. Table 2 reports the market share for the top 10 producers in 2005. Combined, the market share of these 10 firms was 68.2 percent, almost identical to that of the top three producers in 2000. The top still is dominated by JVs between SOEs (state-owned enterprises) and the leading international auto companies; however Chery, Changan and Geely joined Xiali as emerging domestic car producers. In total, domestic (100-percent Chinese) car producers currently represent roughly 30 percent of the total passenger car market. Notably, FAW-Audi and SAIC-VW, two firms that developed under the high pre-WTO protective tariff, failed to leverage their early advantages and in 2005 their production volumes were not much different from what they were in 2000.7

TABLE 2

MARKET SHARE IN CHINA, THE TOP 10 (2005)

Firm Type Sales Market Share

(%)

Shanghai GM JV 328 842 10.5

FAW-VW JV 240 120 7.7

Shanghai-VW JV 250 061 8.0

Guangzhou Honda JV 230 773 7.4

Beijing Hyundai JV 233 688 7.5

Xiali (FAW) D 190 019 6.1

Qirui (Chery) D 189 158 6.0

Changan D-JV 168 269 5.3

DF_Nissan JV 157 516 5.0

Geely D 149 869 4.8

Subtotal (top 10) 2 138 295 68.2

Total (all firms) 3 131 950


4-14

-40

-30

-20

-10

010

Cha

nge

in V

ehic

le P

rice

(Per

cent

)

2001 2002 2003 2004 2005

-40

-30

-20

-10

010

Cha

nge

in V

ehic

le P

rice

(Per

cent

)

2001 2002 2003 2004 2005

Domestic car prices have fallen significantly with the falling tariffs, model proliferation and increasing competition in the sector. Trends in auto prices are difficult to estimate precisely in China because of the introduction of new models, changes in the “standard” equipment that models come with, changes in true underlying quality, etc.8 For those models for which we have more than one year of data (40 vehicles in total), the “average” unweighted reduction in car prices was 10 percent between 2000 and 2005, implying reductions in line with the fall in tariffs.9 The median is 8 percent. Price reductions among JVs and Chinese domestic manufacturers are comparable. Press reports suggest similar price pressures in the auto sector in 2006. Figure 4 presents the data for 2001–2005 with the aid of the familiar “box” plot.

FIGURE 4

CHANGE IN VEHICLE PRICES, 2001–2005


4-15

Falling car prices are forcing OEMs to look for ways to lower their costs to remain competitive and retain firm profitability. These include demanding lower prices throughout their supply chain, localizing some of their capital expenditures including tool and die, presses, etc., and shifting some of product development, largely application development work, to China. In probably all but the lowest segments of the Chinese car market, OEMs are doing this without lowering their quality. In fact, we conjecture that increasing competition is requiring firms to upgrade their capabilities and raise overall quality in order to hold onto or to capture market from other firms.

COST PRESSURES IN THE SUPPLY CHAIN

Falling tariffs on both vehicles and auto parts and intense competition in the industry are also having a profound effect on auto-parts suppliers. One manifestation of this is intense cost pressures on suppliers similar to that experienced in the last few years in North America and Europe. This is occurring in the context of enormous growth in the industry, paralleling that which we observe for OEMs. We draw on data from several sources to sketch a picture at the aggregate level for these firms. We then discuss the price pressures and how suppliers are coping with it. Number of Firms, Sales and Gross Value of Industrial Output (GVIO) First, the parts industry is also experiencing significant growth. For the entire vehicle industry (which includes commercial vehicles and motorcycles), we graph in Figure 5 the growth in GVIO (gross value of industrial output) for vehicles, motorcycles, engines and parts suppliers. Unfortunately, parts here include those for both vehicles and motorcycles, but a rising percentage of this is directed to vehicles, and so we are likely underestimating the rate of growth of GVIO for parts suppliers for vehicles. For the entire parts sector, nominal growth averaged 23 percent between 1998 and 2005.


4-16

FIGURE 5

GROWTH IN CHINA’S VEHICLE PARTS SECTOR

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

1998 1999 2000 2001 2002 2003 2004 2005

Year

Sale

s (m

nRM

B)

0

1000

2000

3000

4000

5000

6000

Total Revenue (Million RMB)Number of Firms

0

50000

100000

150000

200000

250000

300000

350000

400000

450000

1998 1999 2000 2001 2002 2003 2004 2005

Year

Sale

s (m

nRM

B)

0

1000

2000

3000

4000

5000

6000

Total Revenue (Million RMB)Number of Firms


4-17

TABLE 3

NUMBER OF FIRMS IN CHINA’S VEHICLE PARTS AND COMPONENTS

SECTOR

1998 1999 2000 2001 2002 2003 2004 2005

Total Number

2320 2349 2496 2724 2968 3605 5625 5604

FIE of which:

WOS

288 71

333 92

402 108

466 148

541 198

675 284

1175 571

1225 614

SOE 711 650 538 474 419 338 393 251

Other 1321 1366 1556 1784 2008 2592 4057 4128

% FIE 12.41 14.18 16.11 17.11 18.23 18.72 20.89 21.86

% WOS 3.06 3.92 4.33 5.43 6.67 7.88 10.15 10.96

% SOE 30.65 27.67 21.55 17.40 14.12 9.38 6.99 4.48

% Other 56.94 58.15 62.34 65.49 67.65 71.90 72.12 73.66

Note: Includes all firms that are SOEs, or non-SOEs with sales greater than 5 million RMB. FIE is a foreign-invested enterprise; WOS, a wholly owned foreign subsidiary; and SOE, state-owned enterprise.

In tables 3, 4 and 5, on the other hand, we draw on enterprise-level data that include all SOEs (state-owned enterprises), plus those non-SOEs with sales of more than 5 million RMB (or slightly more than US$600,000), to capture key aggregate trends in the sector.10 These data point to significant entry and growth in the sector. Between 1998 and 2005, the number of motor vehicle parts and component suppliers increased from 2320 to 5604, with much of the entry occurring after China’s entry into the WTO. We divide firms into state-owned firms, foreign-invested enterprises and an “other” category, which consists largely of private firms, limited liability corporations and a small number of the larger shareholding companies. In absolute terms, the largest increase was in the number of firms falling into our “other” category, especially the strictly private. However, also note the quadrupling in the number of foreign-invested enterprises in the sector from 288 to 1225.

TABLE 4 SUMMARY INFORMATION FOR PARTS AND COMPONENTS FIRMS SUPPLYING THE MOTOR VEHICLE INDUSTRY

1998 1999 2000 2001 2002 2003 2004 2005

Number of Firms 2320 2349 2496 2724 2968 3605 5625 5604

Total Revenue (mn RMB) 81291.22 88518.33 108760 138783.59 185483.8 247633.1 354131.8 404419.5

Average Revenue (mn RMB) 35.04 37.68 43.57 50.95 62.49 68.69 62.96 72.17

Export Ratio (%) 7.83 9.51 11.13 9.58 10.02 11.02 NA 14.38

Profitability 0.054 0.066 0.073 0.081 0.089 0.09 0.07 0.057

% π > 0 68.1 70.97 74.76 77.02 81.23 82.22 79.45 80.96

Profitability/>0 0.093 0.097 0.098 0.1 0.103 0.104 0.09 0.076

Notes:

1. Export ratio is equal to total exports divided by firm sales.

2. Profitability is equal to firm profits divided by firm sales.

3. NA = not available

4-18

BR

AN

DT

& V

AN

BIE

SEB

RO

EC

K

CA

PA

BIL

ITY

BU

ILD

ING

IN C

HIN

A’S A

UT

O SU

PP

LY

CH

AIN

S

TABLE 5

EXPORT RATIOS AND CONTRIBUTION TO TOTAL EXPORTS, BY OWNERSHIP

1998 1999 2000 2001 2002 2003 2004 2005

Export Ratios: (Exports/Sales)*100

All firms 7.83 9.51 11.13 9.58 10.02 11.02 NA 14.38

FIE of which: WOS

19.27 76.46

21.13 69.77

22.86 61.43

17.71 38.8

17.75 36.26

15.95 27.81

NA NA

19.63 29.54

SOE 2.83 2.53 2 1.88 2.45 3.64 NA 5.4

Other 4.22 5.11 5.81 6.43 6.54 8.36 NA 10.39

Contribution to Total Exports (%)

FIE of which: WOS

64.21 35.11

68.13 39.3

71.22 38.18

65.58 38.28

64.67 38.6

58.81 31.16

NA NA

62.16 40.87

SOE 8.29 5.23 2.79 3.68 3.66 2.99 NA 1.66

Other 27.5 26.63 25.99 30.75 31.67 38.19 NA 36.17

Note: Includes all firms that are SOEs, or non-SOEs with sales greater than 5 million RMB. FIE is a foreign-invested enterprise; WOS, a wholly owned foreign subsidiary; and SOE, state-owned enterprise.

4-19


4-20

Overall, nominal sales revenue of all firms increased five-fold, with average revenue per firm doubling. Although firms outside the state sector and without foreign equity are a growing majority, their share of total sales revenue remained relatively constant at half of the total. The largest gains are by foreign-invested enterprises, whose shares of sales increased from 26.1 percent to 45.5 percent. This increase is largely at the expense of the declining state-owned sector. Moreover, among foreign-invested enterprises, wholly owned foreign subsidiaries increased the most, from 3.6 percent to 19.9 percent, reflecting the government’s relaxation of ownership rules in the parts sector. Imports and Exports With the rapid growth in vehicle production output, including that by new OEMs, and the falling tariffs on parts and components after 2000, imports of parts and components and engines also increased rapidly both in absolute terms and on a per manufactured vehicle basis. Drawing on detailed country-level trade data, Figure 6 provides estimates of the value of imported parts and components, plus engines per vehicle produced in China. We show separately in Figure 7 imported engines as a percentage of domestically produced vehicles. Although the data do not allow us to disaggregate between passenger and commercial vehicles, the data are informative. Since 2000, the percentage of engines that was imported more than doubled from 4.1 percent to nearly 10 percent but fell in 2005. We see basically the same behaviour with respect to imported parts (including engines) per vehicle, with a pronounced drop occurring in 2005. Preliminary data for both suggest further drops in 2006.


4-21

FIGURE 6

IMPORTED PARTS AND COMPONENTS

0

1

2

3

4

5

6

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Year

Num

ber o

f veh

icle

s (m

illio

ns)

0

500

1000

1500

2000

2500

$US

Number of vehicles produced

Imported parts and engines pervehicle

0

1

2

3

4

5

6

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Year

Num

ber o

f veh

icle

s (m

illio

ns)

0

500

1000

1500

2000

2500

$US

Number of Vehicles Produced

Imported Parts and EnginesPer Vehicle

0

1

2

3

4

5

6

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Year

Num

ber o

f veh

icle

s (m

illio

ns)

0

500

1000

1500

2000

2500

$US

Number of vehicles produced

Imported parts and engines pervehicle

0

1

2

3

4

5

6

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

Year

Num

ber o

f veh

icle

s (m

illio

ns)

0

500

1000

1500

2000

2500

$US

Number of Vehicles Produced

Imported Parts and EnginesPer Vehicle

FIGURE 7

IMPORTS OF ENGINES


4-22

We report complementary data on exports for the parts sectors. Figure 8 reports China’s total parts and components exports (and imports) on the basis of the United Nations’ country-level trade statistics. For the sample of firms as described above and for the years between 1998–2003 and 2005, we provide in Table 6 total exports (in RMB), the contribution to total exports by ownership and finally, exports as a percentage of sales for each type of firm.11 Overall, exports for these firms grew rapidly and almost doubled as a percentage of total sales in the parts and components industry from 7.8 percent to 14.5 percent. On an annual basis, exports grew 27.6 percent, and doubled in value terms between 2003 and 2005. The bulk of China’s exports are by foreign-invested enterprises — slightly more than 60 percent — with exports by private firms making up most of the rest.12 Although the contribution of wholly owned foreign enterprises to total exports remained relatively constant, an increasing percentage of their attention, as measured by their sales, is directed toward catering to the domestic market and OEMs. The share of their sales going to export fell from 76.5 percent to 29.5 percent between 1998 and 2005.

FIGURE 8

IMPORTS AND EXPORTS OF AUTO PARTS AND COMPONENTS

0

2000

4000

6000

8000

10000

12000

14000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Year

$US

(000

) Exports of Parts andComponentsImports of Parts andComponents

0

2000

4000

6000

8000

10000

12000

14000

1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

Year

$US

(000

) Exports of Parts andComponentsImports of Parts andComponents


4-23

TABLE 6

PROFITABILITY IN THE AUTO-PARTS SECTOR, BY OWNERSHIP

1998 1999 2000 2001 2002 2003 2004 2005

All Firms 0.054 0.066 0.073 0.081 0.089 0.09 0.07 0.057

FIE of which: WOS

0.143 0.103

0.143 0.117

0.143 0.13

0.151 0.161

0.156 0.148

0.149 0.137

0.107 0.096

0.094 0.085

SOE 0.047 0.047 0.046 0.053 0.053 0.065 0.044 0.034

Other 0.087 0.088 0.083 0.077 0.076 0.075 0.08 0.063

A more careful, disaggregated analysis of the behaviour of import data is required, but we are inclined to believe that the increase in the role of imports probably has much less to do with a decision by OEMs (or even first-tier suppliers) after accession to WTO to substitute now less expensive imports for domestically manufactured parts and components than with the lag in the expansion of the domestic parts industry. The lag in this expansion, including the setting up of new supply chains by recent entrants such as Hyundai and Toyota, plus the related short-term difficulties in meeting the rapidly increasing demand of the OEMs, contributed to an expanded role for imports with the boom in the sector.13 The entry by new wholly owned foreign enterprises as well as the expansion and increasing capabilities of existing suppliers in China appear to have stemmed the tide of imports, much like we have seen in other industries in China.14 Our expectation is that the role of imported parts and components will continue to fall.15

Prices and Profitability

Falling vehicle prices (see discussion above), lower tariffs on parts and components and generally increasing competition in the sector all contributed to significant downward pressure on prices facing auto-parts suppliers. Exclusive (or near-exclusive) relationships that suppliers enjoyed in the past with OEMs are increasingly rare; for almost any part or component, there are now multiple potential suppliers. We do not have very good “hard” data on the behaviour of prices in the auto-parts sectors, but interviews with the OEMs and first-tier suppliers in 2006 all suggest target price reductions running between 4 and 6 percent per annum for the last four to five years for both first- and second-tier suppliers, with heterogeneity among the OEMs.


4-24

In this light, trends in firm profitability in the sector are noteworthy. We report in Table 4 information on weighted average profitability in the sector, i.e., firm profitability weighted by firm size, the percentage of firms with positive profits, and average profitability conditional on the firm earning positive profits. We measure profitability here as a percentage of firm sales.16 Table 6, on the other hand, provides profit estimates by type of ownership. Overall, enterprise profitability increases up to 2003 before falling off in both 2004 and 2005. Accompanying this is a slow increase in the percentage of firms earning positive profits, from 68.1 percent in 1998 to 82.2 percent in 2003, followed by a slight decline and then an increase again in 2004 and 2005. Conditional on earning positive profits, profitability averaged roughly 10 percent of sales through 2003 before falling by nearly a quarter. Figure 9 graphs the distribution of profits for suppliers in 1998 and 2005. Note the declining lower tail.

FIGURE 9

DISTRIBUTION OF PROFIT RATES FOR SUPPLIERS, 1998 AND 2005

0.1

.2.3

-.4 -.3 -.2 -.1 0 .1 .2 .3 .4 -.4 -.3 -.2 -.1 0 .1 .2 .3 .4

1998 2005

Frac

tion

Profit RateGraphs by year


4-25

In light of the significant rise in raw material prices over this period, the firm-level data suggest that most firms have been able to reduce their production and operating costs at a rate nearly commensurate with the fall in prices of parts and components through a combination of increases in productivity and other cost-cutting measures. Moreover, overall, quality levels in the supply chain appear to be rising. (See the discussion below on continued quality convergence with the West.We discuss how firms have achieved this in more detail below. Improvements in Costs Based on our interviews with first-tier parts suppliers and OEMs, there are a number of important margins on which suppliers in China are achieving significant reduction in costs demanded by OEMs. These include the following:

• Improvements in manufacturing productivity • Economies of scale • Increases in the efficiency of material use and lower scrap rates • Outsourcing of more labour-intensive operations to other firms • Finding lower-cost sources of intermediate parts and

components, and increasing localization • Lowering inventory costs.

Efforts taken by firms to raise their productivity are part of the routine operations of “good” firms and are often incremental in nature. Steps taken extend from simple modifications to the layout of manufacturing processes to the improvement of quality processes overall on the shop floor, often with the aim of reducing the amount of “rework” that needs to be done in the assembly process. In the context of rapidly growing demand, firms are also trying to take advantage of important economies of scale in production and sharply falling average fixed costs. At a slightly higher level, we begin to see tighter integration between product and production engineering as firms design products with the ease of manufacturability a key consideration. Better firms are continually evaluating their manufacturing processes to identify key bottlenecks and constraints with an eye to lowering overall labour costs through re-organizing the workflow. Production processes are carefully charted and timed. Firms have also become more acutely aware of the costs of low quality, including the added labour costs associated with reworking material to satisfy rising quality requirements set by customers.17 Investments in worker training, increasing interaction between product and production engineers as well as heightened attention to equipment and machinery maintenance and set-up are all essential to quality improvements on the


4-26

line. Rising raw material costs have also helped make firms much more sensitive to the costs of material waste (see box below). For example, firms involved in cutting, stamping or pressing of metal sheets, common in the exhaust industry, increasingly do so to maximize the surface area of the materials used. Firms are also simultaneously reassessing the optimal degree of vertical integration, as well as the nature of their sourcing decisions. The potential shifts in sourcing include: Made in-house (MIH) → JV/WOS/Domestic firm

Import → Made in-house Import → JV/WOS/Domestic JV/WOS → Domestic Chinese firm

Reducing Scrap Rates

In our 2003 interviews (see Sutton 2004), high scrap rates were common among exhaust suppliers in China. Scrap rates were typically between 1.5 to 2 percent, comparable to the direct labour costs in the same firms. By 2006, the average was well below 1 percent, with half of the eight firms we interviewed achieving rates of less than 0.5 percent. These reductions were achieved through several means. First, firms worked with suppliers to improve the quality of the materials used. Exhaust firms, for example, often buy pre-cut sections of pipe for use in the exhaust system or in subassembly such as the muffler. Welding involving the pipe requires that the section be cut within very tight tolerances. Failure of suppliers to deliver within these tolerances lowered the quality of the welds and increased the number of defects that could not be reworked. Second, firms switched to higher-quality moulds for use in pipe-bending operations. This helped reduce the “wrinkling” experienced in the manufacturing process and directly lowered scrap. Third, firms began to pay much more attention to machine set-up and tooling in order to increase the precision and exactness of the welds. And fourth, firms invested more heavily in the training of machine operators to make them better aware of the sources of poor quality and high scrap, and what they could do to reduce it.


4-27

A number of factors are influencing the speed and direction of these shifts. The shift from MIH to outsourcing largely reflects the capabilities outside the first-tier suppliers and the ability to find second-tier suppliers capable of meeting cost and quality requirements. In the case of seats, exhausts and braking systems, we now see numerous examples of more labour-intensive, lower-value-added components that are slightly less demanding in quality being outsourced. This is especially true in areas involving stamping, pressing and moulding. We also see import substitution occurring for more “quality-sensitive” components that we link to the emergence of new domestic suppliers, usually recently established foreign-invested firms, set up for the express purpose of serving the domestic market. Between these two examples, we observe firms looking for lower-cost, 100-percent domestic alternatives to foreign-invested firms operating in China. In working with 100-percent domestic suppliers, a critical determinant of the success of the first-tier supplier is often the first-tier supplier’s own capabilities and ability to work with the second-tier suppliers in improving production processes so quality and cost targets can be met. In the other direction, we observe some firms doing things in-house that they formerly outsourced. Here, increases in market demand and the opportunity to take advantage of economies of scale in production seem to be critical to justifying certain capital expenditures by the firms. How rapidly these changes are occurring is often heavily tied to the willingness of (foreign) OEMs to release parts and components used by their first-tier suppliers for localization. As noted at the outset, we observe significant heterogeneity in China across the OEMs, which reflect each individual OEM’s overall global sourcing strategies, quality requirements, as well as the engineering and design capabilities of the OEMs’ operations in China. Firms (both OEMs and first-tier suppliers) differ significantly in terms of their “in-house” ability and manpower committed to working with local suppliers to upgrade their capabilities and thereby meet demanding quality requirements. Firms also differ in terms of their ability (and willingness) to redesign their product (and the parts and components that go into them) in such a way to facilitate local sourcing without compromising either functionality or quality. The box below provides information on a particularly successful firm. A significant number of foreign-owned first-tier suppliers expressed frustration over the speed with which localization was being allowed by OEMs. They felt that costs could be lowered by as much as 20 to 25 percent by sourcing to 100-percent domestic firms and that quality would not be compromised in the process. Further localization of the supply chain offers much greater room for cost reductions than do further improvements in productivity.


4-28

Rising in-house capabilities

A major brake company serving OEMs in China, now exporting as part of the global platform of one of these OEMs, is developing significant engineering capabilities within the JV. Drawing on the basic (core) technology of their overseas partner, they are now capable of developing braking systems for OEMs in China. Their engineers have benefited from overseas training in the R&D centres of their foreign partner and from extended visits of engineers from the parent company. As well, working with OEMs, they have succeeded in redesigning parts and components to facilitate local sourcing, e.g., they redesigned a part so it could be machined using a slightly less sophisticated (and less expensive) multiple-spindle, multiple-axel numerically controlled lathe. The same firm reported that localization rates for brake calipers increased from only 10 to 20 percent in 2002 when they began producing to 83 percent at the end of 2003 and then to 93 percent in 2006. For the ABS systems they produce, localization was 65 percent in 2005. For the actuation rate, they achieved localization rates of 80 percent in 2006. One of the key parts of the ABS system that they are not able to source locally or produce themselves is the valves. The largest constraint was not capability but rather significant economies of scale in production.

Finally, high inventory levels and carrying costs were endemic in China’s SOEs and a product of “soft” finance. In an industry in which OEM production is often organized JIT (just-in-time) and JIS (just-in-sequence), suppliers — first-tier as well as second — are increasingly aware of the costs of carrying high inventory levels. High inventory levels of raw materials, intermediates or final goods are symptomatic of several things including the role of imported raw materials or intermediates; uncertainty in the domestic supply chain; problems in their own manufacturing processes that require them to keep a “buffer” of final output on hand; and limited flexibility in being able to accommodate day-to-day changes in the structure of demand. In the better firms we visited, turnover ratios (ratio of inventory to sales) have been rising, albeit at levels still significantly lower than we observe in the best firms internationally.


4-29

CONTINUED QUALITY CONVERGENCE WITH THE WEST

OEMs and first-tier component suppliers have been able to lower prices while achieving quality levels that are often converging with those of comparable firms overseas. This is especially true among JVs and WOS, but rising quality levels have also been documented for some domestic OEMs, e.g., Chery, especially for their class-B vehicles such as the QQ. In Figure 10, we reproduce the distribution of defect rates, measured in terms of PPMs, obtained in our earlier study for first-tier suppliers to a major joint-venture OEM in 2003. (We also include the comparable numbers for India.) Most of the suppliers had PPMs below 100, considered an industry benchmark at the time. Although we do not have similar data for 2006, interviews with 8 major OEMs in 2006 and nearly 25 first-tier suppliers suggest that quality levels have generally been rising among first-tier suppliers. However, there are exceptions.

FIGURE 10

SUPPLIER DEFECT RATES FOR NEW GENERATION CAR MAKERS

0102030405060

<100

ppm

100-3

00-70

0-15

00-30

00-70

00

-1200

0

-2500

0

>250

00

Defect Rates: PPM

# of

Sup

plie

rs

ChinaIndia

0102030405060

<100

ppm

100-3

00-70

0-15

00-30

00-70

00

-1200

0

-2500

0

>250

00

Defect Rates: PPM

# of

Sup

plie

rs

ChinaIndia


4-30

There are, however, exceptions to this general increase in quality. The information on external (or customer) defect rates for seats and exhaust suppliers that we interviewed illustrates this. These are defect rates as measured by the customer. In 2003, median PPM in our sample of seat suppliers was 50 but was over 1000 for one firm. By 2006, the external PPM was below 50 for five of seven suppliers and below 20 for four of seven suppliers. The firm with an external PPM of over 2000 is exclusively supplying a Chinese OEM. For exhaust suppliers, on the other hand, external PPMs fell from a median of 100 to less than 20 for five of six suppliers for which we were able to collect data. A firm with an external PPM of 2500 is at risk of losing its business. Internal PPMs (these are the number of units that were either pulled from the line or did not pass first inspection) fell slightly less, but higher quality requirements, increasing complexity in the product produced, etc. blur some of the comparison. One of the important observations made by Sutton (2004) was the sharp drop-off in quality levels between the first- and second-tier firms; the latter were largely 100-percent domestic firms. But based on firm interviews and data for a small number of first-tier suppliers, we find indications of significant improvements in the defect rates of their second-tier suppliers going forward. In Table 7, we provide information on PPMs for second-tier suppliers to six first-tier suppliers. For three of these second-tier suppliers, we have information for both 2003 and 2006. We identify their major product and the region in which they are located. These data suggest significant improvement over the last three years. For the two best firms, 90 percent of the suppliers had defect rates below 100, and nearly 60 percent were below 50.


4-31

TABLE 7

PPMS FOR SECOND-TIER SUPPLIERS (% OF TOTAL NUMBER OF

SUPPLIERS WITH PPMS IN EACH INTERVAL)

Product Brakes Brakes Exhausts Seats

Region East West East South

PPM 2006 %

2003 %

2006 %

2003 %

2006 %

2003 %

2006 %

< 50 58 8 30 5 60 20 19

50–100 22 20 10 7 30 70 48

100–300 5 21 15 8 5 5 22

300–500 10 22 15 25 5 5 7

500–1000 1 14 10 14 4

1000–2500 4 9 8 18

2500–5000 6 4 8

5000+ 8 15

Average PPM

158.5 634.5 1070 1967.5 67.5 87.5 142.75

There is much in the popular press in North America and Europe about the low crash-test ratings for a number of Chinese-made (100-percent domestic firms) vehicles hoping to enter the North American market. These examples represent the lower tail of the distribution. More telling for our purposes are decisions of Volkswagen and Toyota to retool and introduce the new Jetta and Camry in 2006 in China at the same time as in North America. Exports by Guangzhou Honda of the Fit to Europe, and exports of engines by Toyota to the CAMI plant here in Canada reflect improvements in the quality of the products being made and new export opportunities. In short, rising quality levels throughout the supply chain are both an indication of rising capabilities among these firms and a reminder of the rising threshold that domestic firms must achieve in order to supply and sell locally. A good indicator of the steps being taken in the sector is the number of firms that are now ISO/TS 16949-certified, an exclusive certification in the auto sector. As of December 2005, 2151 firms in China had received the designation. Of course, some firms experience considerable difficulty in China and are left to supply to a small tail of the distribution of vehicle manufacturers that are having similar difficulty in achieving rising quality thresholds and thus are competing largely on price.


4-32

LOCALIZATION OF PRODUCT DEVELOPMENT AND R&D Perhaps the most significant change influencing the parts and components industry is the increasing localization of product development and R&D (application development) by the OEMs for products that are being manufactured in China. There are two important dimensions to this: efforts by overseas OEMs that are producing in China through JVs, and those by 100-percent domestic firms. A number of important factors help explain the decision of some OEMs to shift more of this work to China. It is important to recognize at the outset that there are differences among the OEMs that often reflect the larger global strategies of the firms. First are the cost considerations. Application development costs are often much less expensive in China than they are elsewhere, especially engineering salaries.18 Also related is the fact that localization allows the OEM to work closely with local suppliers and find ways to lower production costs through modest component redesign and modification. This can lead to increases in local sourcing opportunities without compromising either the functionality or quality of the part or system that is being produced. Second, we observe growing maturity of the domestic market. Early car models introduced by OEMs to China were typically slightly older versions of models manufactured elsewhere. The VW Santana is a good example. Subsequently, some OEMs introduced nearly identical versions of cars that were being manufactured overseas, with their overseas first-tier suppliers investing in China and making up most of the first tier in China. Lower-than-expected sales in these cases have made OEMs more acutely aware of the potential benefits of modifying designs, albeit modestly, to better “fit” the preferences of Chinese car buyers, who increasingly are households. As we noted at the outset, even small design modifications can have much larger effects for the supply chain. Rapid growth in the size of the domestic market is allowing these costs to be spread over higher volumes. And third, localization of this work can help to reduce significantly the time it takes to get a new model to market, which is extremely important in the highly competitive Chinese car market. Over the last few years, there has been growing model proliferation in China and for firms pursuing this strategy, the time it takes to get a new car to market can be extremely important. There are differences among the overseas OEMs, but a growing number of them are increasing the amount of the design and development being done in China related to new models. This shift increases significantly the capabilities (design and application development) that are required of their first-tier suppliers in China who


4-33

will work with the OEM from the outset. First-tier suppliers to these firms told us of their need to invest significantly in these capabilities or risk losing the business of the OEM. Localization of product development and R&D throughout the supply chain is also being spurred by the emergence of firms such as Chery, Geely and Brilliance. In addition to having higher localization rates, these firms have also been much more likely to source in China from 100-percent domestic firms than from either JVs or WOS. A comparison we made of first-tier suppliers for major parts and systems (~ 60–75 suppliers per firm) among two domestic, three Asian, two North American and two European OEMs operating in China is suggestive in this regard (see Table 8). For Chinese OEMs, 61 percent of the suppliers they identified were domestic firms, and the rest were largely JVs. For the Asian OEMs, on the other hand, less than 5 percent of their suppliers were domestic. For the North American OEMs, 27 percent were domestic firms. And there were also differences between the Chinese and North American OEMs in the technological and manufacturing “sophistication” of the parts or systems that were being procured domestically. Firms such as Chery and Geely are providing to 100-percent domestic suppliers, as well as to local JVs, important opportunities to invest in their application development capabilities and to be more deeply involved in the design, prototype development, testing and mass production of important systems in the car.19 A number of major JVs we interviewed expressed similar sentiments about the emerging “learning” opportunities provided locally by these firms, and how they hoped to build on them.20 The process of capability building can be a painful one, and weaknesses in areas such as system integration on the part of domestic OEMs often present a unique set of issues for their suppliers. However, first-tier suppliers were nearly universal in how impressed they were with the speed of learning on the part of firms like Chery. The rapid proliferation in the number of models being sold by these firms is testimony to the opportunities being provided.


4-34

TABLE 8

SOURCING BY OEMS IN CHINA (% OF 1ST TIER SUPPLIERS)

OEM JV/WOS Domestic Overseas

(Imported) European 86.0 14.0 0.0 European 68.3 23.8 7.9 U.S. 57.1 14.3 24.5 U.S. 58.5 39.6 3.8 Asian 64.4 2.2 33.3 Asian 85.5 4.8 9.7 Asian 67.9 9.4 22.6 China 41.8 58.2 0 China 36.6 63.4 0 Average (non-Chinese OEMs)

69.7 15.4 14.5

Average (Chinese OEMs)

39.2 60.8 0

Average (all) 62.9 25.5 11.3


4-35

SOME POTENTIAL IMPLICATIONS FOR OVERSEAS PART SUPPLIERS

EVELOPMENTS IN THE CHINESE AUTO SECTOR have important implications for the overseas auto sector moving forward. As we

noted at the outset, strategies of the OEMs differ and each strategy has its own set of implications for overseas firms. At the risk of some simplification, we identified these as (a) integration into the global supply chain, (b) cautious localization and (c) aggressive localization. But there is no escaping a more general observation and a positive dynamic at work: capabilities in the supply chain, both in terms of manufacturing capabilities, and in terms of the ability to carry out application development and some product development, are rising rapidly in China, albeit unevenly. These capabilities in the supply chain, combined with those in the OEMs operating in China, point to the likelihood of rising exports from China in the form of both vehicles and parts and components. We anticipate OEMs using China as an important platform for manufacturing (and later developing) smaller, more fuel-efficient vehicles. This is the most important market segment for cars in China (and Asia for that matter) where in 2005 nearly two thirds of all cars produced had engines smaller than 1.6 litres. Export of the Honda Fit to Europe and the recent agreement between Daimler Chrysler and Chery for Chery to produce cars for sale in North America may be the tip of the iceberg. Ongoing investments by first-tier suppliers operating in China in new R&D or technical centres catering to class-B vehicles will only strengthen China’s capabilities in this segment. Although it may be 5 to 10 years before vehicles produced by 100-percent domestic firms in China can meet the safety and quality requirements demanded in North America and Europe, the acceleration in the pace of capability building in the industry suggests that it may be nearer to 5 years.21 Overseas firms can also expect more competition from firms operating in China in the parts and components industry, either supplying OEMs directly, or in the after-sales markets. We do not have data that provide a clear breakdown, but recall from our earlier discussion that exports by foreign-invested firms in China represent nearly 60 percent of all exports. This comes in several forms including the export of smaller parts and components that go into larger systems assembled in North America and the export of complete assemblies or subassemblies. Major international parts suppliers, especially those in North America, are tapping their JVs or WOS first-tier suppliers in China as less expensive sources of supply and as a vehicle through which good second-tier suppliers can be identified. The opportunities to

D


4-36

do so will only increase as OEMs reduce their total number of vehicle platforms and try to harmonize parts and components across these platforms. Exports of domestic Chinese firms, on the other hand, are much more likely to be going to the after-sales market and will affect firms for whom these markets are a major outlet. Figure 11 which graphs by region the trade balance (X-M) in the parts and components sector with China, shows the large and rising deficit of North America vis-à-vis China.

FIGURE 11

NET EXPORTS (X-M) PARTS AND ENGINES BY COUNTRY (REGION)

-2000

-1000

0

1000

2000

3000

4000

5000

Japa

n

Asia (o

ther)

NAFTA

Europe

Latin

America

Africa

Middle

East

Other

$US,

mill

ion 1995

20002005

-2000

-1000

0

1000

2000

3000

4000

5000

Japa

n

Asia (o

ther)

NAFTA

Europe

Latin

America

Africa

Middle

East

Other

$US,

mill

ion 1995

20002005


4-37

One other noteworthy trend is the investment by Chinese parts suppliers such as Wanxiang, the leading private supplier of parts in China, in smaller parts and components manufacturers in North America.22 One motivation for these acquisitions is the desire to obtain technical “know-how,” but equally important is their desire to access the sales distribution network of those firms. This is part of a more general phenomenon we are observing in the manufacturing sector that is being encouraged by the Chinese government, and it is made easier with looser controls on overseas investments. These overseas acquisitions may become an important conduit in the future for Chinese exports. Finally, the emergence and rapid growth of the auto industry in China reminds us what it takes to be a successful first-tier supplier globally. Nissan, for example, identified three (and only three) criteria:

World-class production quality at lowest cost World-class design and redesign capabilities Worldwide reach (production and design).

One of the problems facing domestic Chinese parts suppliers with aspirations of becoming an international first-tier supplier is that they are lacking in one or more of the above. The same may be true for some Canadian suppliers, especially in terms of their global reach, or even technical know-how. The growing role of electronics and electronic systems in cars is significantly altering the capabilities that a firm must have to remain a first-tier supplier. In our visit to suppliers in Japan, for example, we interviewed a number of firms that were the product of recent mergers or ventures between firms, which combined had the required capabilities. A number of firms we interviewed that did not have the capabilities had slipped to being second- tier suppliers. More generally, given the size and expected future growth of the Chinese market, the ability to service that market may become critical to retaining a major role as a first-tier supplier elsewhere.23 Having operations in China also provides opportunities for lower-cost sourcing that can help firms remain competitive in other markets.


4-38

ENDNOTES

1 The identity of all plants is concealed for confidentiality reasons.

2 China’s exports of “motor vehicle parts and accessories” (which excluding engines and tires) totaled US$5.75 billion in 2003 but rose to US$12.29 billion by 2005. Passenger vehicle exports were only US$61.2 million in 2003 and US$729.2 million in 2005.

3 Some OEMs are pursuing global strategies intermediate between (b) and (c): trying to increase the share of parts common among global vehicle families but maintaining high degrees of product differentiation across global markets.

4 Figures through the first three quarters of 2007 suggest China’s total vehicle production in 2007 will be in the vicinity of 8.5 million units.

5 SUVs and MPVs are typically included in passenger cars but are included under buses, or “keche,” in the Chinese classification system.

6 These estimates were provided to us by China’s Automotive and Technical Research Centre (CATARC).

7 Output for both firms, however, expanded significantly in 2006 and 2007.

8 Failure to control for increases in the “standard” equipment and improvement in quality over time would lead to an underestimate in the rate of price reductions.

9 Unweighted by production volume, for example.

10 Firms with sales of less than 5 million RMB represent a relatively small percentage of the industry, so their omission does not seriously bias interpretation.

11 We are missing data on firm exports for 2004 and are in the process of obtaining it.

12 There are also differences in the markets the two types of firms are serving. Exports by foreign-owned enterprises are much more likely to go to overseas OEMs, while private firms’ exports are primarily serving the after-sales market.

13 For any new OEM entering the market, such as Hyundai, we expect it will take several years for them to develop their local supply chain of first-tier suppliers. During the first three or four years, the OEM would be more dependent on imports.

14 For the case of television, see Brandt, Rawski and Sutton (forthcoming).

15 The expansion in wholly owned foreign enterprises will allow more “technologically-sensitive” parts and component systems to be manufactured in China because of the more secure intellectual property environment compared to that of a JV.

16 Calculating firm profitability as a percentage of net fixed assets paints a similar picture, albeit a more rapid increase through 2003, and then a fall in 2004 and 2005.

17 Of course, the largest cost of poor quality is lost business. Firms unable to satisfy the rising quality requirements of their customers will ultimately lose their business to competitors.

18 Engineering salaries in China run typically about a sixth of the cost in North America. It is important to remember, however, that personnel costs are only about a third of total engineering costs; the rest is made up of the costs of testing equipment, software, buildings and vehicle prototype. Some of these costs will be very similar across countries. Differences in productivity also offset some of the cost differentials.

19 At the same time, Chery has outsourced (and in several cases more directly collaborated with) engineering, design and testing to leading international firms.


4-39

20 A number of first-tier suppliers we interviewed were in the process of setting up major R&D facilities in China with the aim of serving the “B,” or small car, market segment.

21 In a number of other industries we have examined, the length of time it is taking firms to become internationally competitive is shrinking compared to the experiences of Korea, Taiwan or even Japan.

22 In September of 2007, Wanxiang made a major acquisition of plants of the bankrupt parts supplier Dana located in the United States and Mexico.

23 JD Power predicts that China will be the second-largest market by 2010, with vehicles sales of over 10 million. This estimate may be low.

BIBLIOGRAPHY

Brandt, Loren, Thomas Rawski and John Sutton. 2008. “China’s

Industrial Development.” In China’s Great Economic Transformation, edited by Loren Brandt and Thomas Rawski. Cambridge (MA): Cambridge University Press.

Sutton, John. 2004. “The Auto-Component Supply Chain in China and

India: A Benchmarking Study.” Mimeo, London School of Economics.


4-40

APPENDIX LIST OF FIRMS INTERVIEWED IN CHINA Firm Name Location Firm Type Model Chery Wuhu, Anhui OEM Wuhu Hean Seats Honghu Exhausts SGM Shanghai OEM Regal Arvin Exhausts Yanfeng JC Seats Continental Brakes Changan Ford Chongqing OEM Focus CST Brakes Chongqing Yanfeng JC Seats Hongyu Exhaust DF Honda Guangzhou OEM Accord TS Seats Seats Foshan Exhausts Nissin Brakes DF Nissan Huadong OEM Teanna DF JS Seats Huizhou DF Yijin Exhausts Shanghai VW Shanghai OEM Passat Shanghai Walker Exhausts Yanfeng Visteon Misc UAES Elec control unit FAW VW Changchun OEM Golf Dalian Walker (Changchun) Exhaust Johnson Control Seat Siemens VDO Elec control unit Toyota (Tianjin) Tianjin OEM Corolla Toyota Textile Seats Tianjin Sango Exhausts ATL Brake discs and rotors Hyundai Beijing OEM Sonata Sejong Exhausts Beijing Johnson Control Seats

Documents

University of Toronto 4 Capability Building in China’s ...econweb2012.econ.kuleuven.ac.be/.../CV/bvb06rotman... · Original equipment manufacturers (OEMs) design the vehicles and