Next for the West Are Cars “Made in China”

The road to Damascus is a strange place to assess the future of one of the world's most important industries.Yet the Syrian capital is the focus of an experiment that has the potential to reshape the automotive business.

For the past year or so, several Chinese car companies have been shipping vehicles to countries in the Middle East in a trial run for exports. From there, the Chinese are planning an assault on the car markets of the developed world. Chery, the most ambitious, plans to launch five specially developed models in the US in two years' time.

These may be early stages but the Syrian experiment could be the start of an unstoppable shift in the global automotive sector. A first sign came when Shanghai Automotive Industry Corporation (SAIC) - which last year bought Ssangyong, a South Korean maker of sports utility vehicles - recently tried to take control of MG Rover.

From T-shirts to televisions, Chinese manufacturers have cut a swath through a number of industries over the past 10 years, as aggressive entrepreneurs harnessed low-cost, hard-working labour. Goods made in China have come to dominate consumer electronics, white goods, furniture and textiles among other sectors.

"Looking at what has happened in other industries: it is clear that the Chinese companies are good at competing on price and cost," says Sun Jian, a consultant with AT Kearney in Shanghai. "In 10 years, the local carmakers will become strong competitors."

Those other sectors employ many thousands of people but they pale in comparison with the motor industry, which last year accounted for 4 per cent of US gross domestic product. It is crucial in Germany, where one in seven jobs relies directly or indirectly on the car industry. If Chinese manufacturers can repeat the same low-cost formula that they have used so successfully in consumer electronics, they could prompt the rest of the motor industry to transfer significant parts of its production to China. With popular anxiety about the competitive threat from China on the rise, the prospect of China exporting huge volumes of cheap cars is one to strike fear in many western politicians.

From the start of China's economic liberalisation in the 1980s, the government has had its eye on creating an indigenous car industry. By forcing multinationals to enter the country through joint ventures, Beijing's leadership hoped the Chinese companies would quickly learn the necessary skills. However, progress was slow. Although many local companies made a good living through the joint ventures, their partners let them go only so far. They learnt about manufacturing but they were shut out of the design and research needed to create their own brands.

By 2004, the government was getting frustrated. A new policy document made clear that it wanted local companies to take aggressive steps to develop their own technologies and brands. One industry executive says the big Chinese companies were ordered to hurry up.

SAIC, which is controlled by the Shanghai city government, is the Chinese company that has made the biggest effort to acquire development skills. Indeed, it could still end up with some important Rover assets. It believes it has acquired exclusive intellectual property rights to two Rover models, although this is disputed by the administrators of the UK company.

The real prize from the originally proposed deal would have been the engineering teams, car development capabilities and the Rover brand. SAIC has since hired Ricardo, a British engineering consultancy, to conduct research and development. According to people close to the company, Hu Maoyuan, SAIC's long-standing chairman, begins every internal meeting with a pledge to develop the company's own brands.

Geely is one company trying out its wares in Syria. Unlike most of its Chinese rivals, Geely is a private company, which some analysts believe might give it an entrepreneurial edge over its state-owned rivals. Founder Li Shufu, a farmer's son, made his fortune manufacturing motorcycles and has turned his attention to cars. Brilliance China, BMW's new joint venture partner, meanwhile plans to introduce an up-market model into the German market later this year. Brilliance, based in Liaoning province in north-east China, is controlled by the local authority after Yang Rong, its chairman and biggest shareholder, was accused of unspecified "economic crimes" and fled the country.

The company that is really making a stir, however, is Chery. Founded only eight years ago in the poor eastern province of Anhui, Chery gained notoriety with its $3,500 (£1,900) QQ mini - a car that General Motors claims is so similar to its own Korean-designed Chevrolet Spark that it is taking legal action against the company in China.

Earlier this year, Chery announced a plan to start selling cars in the US in 2007 with a target of 250,000 vehicles in its first year, reaching 1m within five years. Annual sales of 250,000 would give Chery a market share in the US similar to that of Volkswagen or BMW, according to Goldman Sachs, and account for 10 per cent of all car imports into the US.

To build models especially for the US market, Chery has hired AVI, an Austrian company, to develop the engines and two Italian design companies including Bertone, which has developed cars for Lamborghini and Maserati. It has also contracted a distributor in the US by the name of Malcolm Bricklin, whose previous experience includes bringing the Yugo and the Subaru to the US market.

Chery does not plan to squeeze its way into the market by selling low-margin mini-cars, as other new entrants have done. Instead, it is aiming for the premium end of the market but at prices 30 per cent below those of its rivals. Mr Bricklin believes China's car industry can establish itself in developed markets much more quickly than the 20 years it took the Japanese or the 10 years the South Koreans needed. "Everything is speeded up," Mr Bricklin says. "Everyone knows everything because all the mistakes have been made before."

When the Japanese started exporting cars, they had to overcome the country's reputation for unappealing products, as well as the psychological barrier of having been at war with the US only a generation before. "There were so many disadvantages that Japan had that China doesn't have," says Mr Bricklin, who runs a company called Visionary Vehicles.

There is no shortage of ambition on the part of the Chinese companies. Yet, as they devise their strategies for entering the car markets in rich countries, they face a series of obstacles. Selling cars in the US would require skills in design, branding and marketing that Chinese companies have not yet shown a great aptitude for. "The branding and R&D that you need in these industries are not easy for Chinese companies; it is not where their strengths are," says Arthur Kroeber, editor of China Economic Quarterly. "I do not have a lot of optimism about Chinese finished goods over the next five to seven years." Lin Xiaogang, chief executive of Huachen Auto Group, a Chinese car manufacturer, adds: "It is difficult to compete with those companies that have accumulated brand equity over a number of years."

Quality will be another vital issue. For any newcomer, a failure to produce reliable cars can be fatal. This is especially true for a product that will have a "Made in China" tag, with all the associations of low-cost manufacturing that this carries.

Moving too quickly is risky. While Hyundai is now considered a great success story, Jim Park, an industry consultant, points out that its entry into the US in the early 1990s was plagued with problems about quality. "Hyundai messed it up for other Korean companies for a decade in the US," he says. "They [the Chinese] will be aggressive, but they need to be careful." Sun Jian, at AT Kearney, adds: "Whoever is first, if they get it wrong, they hurt their brand and on a larger scale they turn people away from Chinese-made cars." Mr Bricklin dismisses these concerns. "Cars are going to be coming all over the place from China," he says. "This [argument] that they are not going to get the quality is just nonsense."

Finance could be another problem. Developing and marketing new models requires deep pockets. SAIC and Chery can at least rely on strong backing from their respective local governments. Geely, on the other hand, has the problems that all private companies face in China in trying to secure funding. It was recently listed on the Hong Kong stock market but only through the backdoor acquisition of another listed company.

In addition, the Chinese do not yet have the luxury of a secure home market. When Japanese and South Korean companies began developing their own models, they could rely on having a large chunk of their domestic market for a long period, which both guaranteed a reasonable flow of revenues and gave them some space for trial and error. The Chinese companies are trying to introduce their models into a domestic market that will soon be populated by every big multinational carmaker and that the former head of Volkswagen in China recently called "the most competitive market in the world".

The multinationals are also not going to let the Chinese wander in unhindered. In an indication of the response they can expect, GM said last month it would try to prevent Chery from registering a trademark in the US on the grounds that its brand was too similar to Chevy, the nickname for GM's Chevrolet brand.

Advisers to Geely say that, when it tried to buy a specialised machine tool used to make gearboxes, the company took more than a year to find a supplier willing to sell to it - a delay they put down to pressure on the machinemaker from multinationals. d4 Nor is it yet much cheaper to produce cars in China. Although assembly line workers at Daimler- Chrysler's Chinese factories earn $1.95 an hour, compared with $49.50 at its German plants and $36.50 in the US, labour is only a small part of the overall cost. Many components have to be imported, the factories are sub-scale and logistics can be inefficient in China. "Even today, many of the components used in passenger cars are priced above world market levels," says Jack Perkowski, the American founder and chief executive of Asimco, a Chinese parts maker. As factories grow and local parts prices drop, the cost of Chinese vehicles will also fall, but this will take time.

There are plenty of reasons, therefore, why the Chinese companies might stumble. However, if they succeed, it could force the automotive industry into a big rethink. Every one of the world's biggest car companies has been plunging investment into China in recent years with an eye to supplying the country's growing middle class. As yet, only Honda has set up a plant to make cars specifically for the export market. But as costs in China fall as a result of rising volumes and economies of scale, the other companies will begin to think much harder about using China as an export base.

The political consequences of this are not hard to predict. When DaimlerChrysler raised the prospect last month of exporting cars from China to the US to sell under its Chrysler badge, American unions reacted angrily and Chrysler was forced into a rapid retraction. "Anyone who is familiar with the union situation and the political situation here will tell you there will be a backlash," one Chrysler official said.

The US is already talking tough about China's currency and its exports of textiles. In a recent article called "The end of the love affair with China", Jonathan Anderson, a UBS economist, described how the developed world had moved in recent months from admiration at China's economic advances to trepidation at the competitive threat. If China were to start taking big chunks of the car markets in rich countries, any romance would truly be over.

Spending is big in an awkward market

The surest way to rile a China-based automotive executive is to ask: is China the new Brazil?

Back in the mid-1990s, when Brazil was emerging from two decades of rampant inflation, the automotive industry pumped in billions of dollars of investment in the hope that a sustained consumer boom was under way. A few years later, the economy hit a wall, car sales slumped and the new factories were left running at only half capacity, incurring big losses.

This decade, China has witnessed dramatic growth in car sales, which prompted an unprecedented investment spree by global vehicle makers. According to Automotive Resources Asia, a consultancy based in Shanghai, multinationals will invest $12bn-$14bn (€10bn-€11bn) in China over the next five years.

Yet just as some of these new factories are coming on stream, the rate of growth in the market has slowed sharply. Within a few years, analysts believe, capacity could be close to 6m cars a year while domestic demand will be around 3m.

So does the Brazil comparison hold? At least in one respect it does. The mid-1990s boom in Brazil was partly a one-off release of pent-up demand from 20 years of instability. The recent boom in China has been fuelled by the throwing off of economic and political restraints that depressed consumption.

However, there is a second factor driving the Chinese market that makes it very different from Brazil. The Chinese economy is growing at around 9 per cent a year and is not expected to slow sharply for a number of years. Every year, hundreds of thousands of people in China begin earning enough money to make them potential car buyers - and barely 1 per cent of the population have one. The expected growth rate of demand, with estimates of 10-15 per cent a year, is well above any other significant market in the world. It is likely, though, to be a very different market from the one car makers have experienced so far in China, where the first movers enjoyed the highest profit margins in the world for several years.

According to Clint Laurent, chief executive of Asian Demographics in Hong Kong, many of the initial customers were government and company bosses or "petrol-heads", people prepared to spend a large sum for a fancy vehicle. The new generation of customers wants practical, smaller cars and is more cost-conscious.

Chinese companies appear to have stolen a march in attracting these new customers. The fastest growing model over the last few months has been Chery's QQ mini, one of the cheapest cars in the world, which has doubled sales since last year.

Rising capacity and slowing growth have led to steep cuts in prices on many vehicles, while companies are having to work much harder to sell their brands. This has hammered profits at the joint ventures of the western manufacturers that lead the market. Volkswagen, the German car maker that is China's biggest, lost €17m ($21m) in the country in the first three months of the year compared with a €106m profit in the same period last year. Chinese profits at General Motors of the US, whose joint venture with Shanghai Automotive Industry Corp is the second biggest in the country, slid 80 per cent to $33m.

Kate Zhu, an analyst at Morgan Stanley in Hong Kong, summarises the outlook as: "Worsening overcapacity, rising costs, tight industry financing, sluggish demand and ongoing price wars." The long-term prospects remain more buoyant than almost anywhere else but the fat profits of the last few years are past.

What Shanghai sought from Longbridge

The world's car manufacturers have long shared the concern of music and video producers about rampant piracy by Chinese companies, with cars copied right down to the steering wheels. But Shanghai Automotive Industry Corp has turned the tables by seizing on intellectual property laws to protect its acquisitions in Britain.

SAIC, China's biggest carmaker, has promised a robust defence of vehicle and engine designs that it bought for £67m last year from MG Rover. It is, in effect, seeking a veto over potential buyers of Rover's remaining assets.

"We reserve the right to fight if needs be," SAIC says, adding that it is willing to license its designs to a buyer of Rover, which is being auctioned by administrators. SAIC has distanced itself from claims of piracy by selling its stake in Chery, a local carmaker accused by General Motors of copying its Daewoo Matiz, sold in China as a Chevrolet Spark.

Suggestions of possible legal action from people close to SAIC have had some effect: at least four potential buyers of Rover are withholding their bids until the intellectual property ownership is clarified.

For SAIC, control of the rights is important. Even though its rescue of Rover has been abandoned, it is preparing to produce two former Rover models in China.

Why was China's biggest carmaker interested in Rover? The answer is that SAIC grew through joint ventures to assemble cars designed by Volkswagen and GM, not by coming up with its own designs.

Rover should have been able to provide SAIC with two key elements it needed to break this reliance on foreign joint ventures.

The first was the Rover marque. "SAIC wants a brand," said one person familiar with its Rover bid. "The Rover name can do well in China, where it is exotic." BMW, which owns the name but had licensed it to Rover, which sub-licensed it to SAIC, may revoke the Chinese rights to use it. But it remains unclear whether SAIC wants to use the marque any longer. Its advisers have warned that the brand depended on British production, just as the BMW name depends on German output.

The second element was the ability to design and engineer cars. SAIC has learnt production and purchasing skills but cannot create a car from scratch. Even for low-technology minibuses it had to turn to Liuzhou Wuling, a rival, and GM for help.

The purchase of designs for the 25 small car, 75 large car and engines has given SAIC the basics and it has taken on Ricardo, the British engineering consultants, to help with research and development work. As a result, SAIC has got most of what it wanted without Rover's heavy losses.

SAIC's decision not to go ahead with the rescue of Rover was vindicated last week. The administrators of Rover revealed that the failed company owed £1.4bn to creditors but that after paying off mortgages it only had assets worth an estimated £85.5m available.

The Chinese company denies that it cherry-picked the best of Rover, saying it bought the designs in good faith to help Rover. "The £67m deal was done to provide them with urgent funding to keep the business afloat whilst the negotiations continued," it said.

Its lawyers are examining whether it can defend the designs it thought it bought against claims by the administrators that it owns only the 2 per cent of the cars that were not shared with the MG brand.

Whatever the final outcome, the legal questions are a sad end for the first foray by a Chinese carmaker into western markets.