8/1/2008 | 22 MINUTE READ

China: A Field Guide

Facebook Share Icon LinkedIn Share Icon Twitter Share Icon Share by EMail icon Print Icon

China is becoming an increasingly adept competitor on the global scene-but with 1.3-billion potential consumers, it is also an emerging market.


Facebook Share Icon LinkedIn Share Icon Twitter Share Icon Share by EMail icon Print Icon

In 2007, as the world worried about the safety of Chinese products, such as pet food ingredients and lead-ladened toys (the U.S. Consumer Product Safety Commission recalled more than 32-million Chinese-made toys that year for various violations), less attention was paid to the fact that China had catapulted into the number-two slot for the total number of vehicles (both commercial and consumer) sold: 7.2 million (nearly all of them within the country's borders), surpassing Japan and gaining fast on the United States. Its economy was continuing its rapid-fire rise, growing 11.9% in 2007, the fifth year of double-digit growth. China had transformed itself into a country of consumers, not solely exporters, on the back of a successful industrialization plan that captured the attention of foreign companies to the tune of $600-billion in new facilities over the past 30 years, more than the U.S. spent on the Marshall Plan to rebuild Europe after World War II. Don't let the YouTube videos of the Chinese-built Brilliance BS6 failing the German ADAC crash tests distract you: China is serious about manufacturing, especially automotive manufacturing.


Building a Manufacturing Foundation

China's economic transformation began to take root in 1980s, when Premiere Deng Xiaoping launched a series of economic reforms transitioning China into a quasi-market economy. His plan allowed the formation of joint venture companies with multinationals, decollectivization of the agriculture sector, and profit retention. These changes provided the foundation for rapid economic growth-China's GDP grew tenfold from 1978 to 2007, standing at $3.25 trillion (compared to $13.84 trillion for the U.S.). Most of that growth came from manufacturing. Manufacturing now accounts for 48% of China's GDP, employing 11% of the total workforce. The lure of low cost labor-wages are as low as $1.40 per hour, compared with $37 in Germany-and a ready-made workforce of more than 795 million (China's total population exceeds 1.3 billion) leaves no shortage of people willing to work long hours for low wages. 

The automotive industry has played a major role in the growth of China's manufacturing sector. According to the Chinese government, total vehicle production in the country shot up from one million units in 1992 to 2 million in 2000, then accelerated to reach 7.2 million in 2006, of which 3.86 million units were passenger cars. There are presently 77 vehicle manufacturing companies in China. However, the surge in manufacturing output isn't restricted to vehicles. China's output of metalcutting machine tools has shot up to 57,300 units annually in 2006, from 17,700 in 2001. Likewise, integrated circuit chip production-a key industry in the eyes of the Chinese central government-shot up from 5.5-billion chips in 1995 to 33-billion chips in 2006.

Now that it has a foothold in the automotive, semiconductor, machine tools and consumer electronics manufacturing sectors, China is preparing to expand its reach into more complex manufacturing. As part of the country's latest five-year plan, which stretches into 2010, it is creating the means to manufacture its own "jumbo aircraft," capable of transporting more than 150 passengers or more than 100 tons in freighter configuration. It will be built by China Aviation Industry Corp., with plans for it to hit the air in 2020. Initially, it will be sold domestically, but plans are in place to compete internationally against Boeing and Airbus. The five-year plan also lays out goals for improving China's position in the manufacturing and development of satellites, biopharmaceuticals and advanced materials. Other priorities include developing nano-machining by atomic force microscopes, micro manufacturing, meso-scale material-forming technologies, and precision magnesium casting systems. These new undertakings do not mean that China plans to turn its back on the auto industry. "The auto industry still remains a key priority, with an emphasis on developing hybrid and electric vehicles. The government is already investing more money in these areas than they are on advancements to the internal-combustion engine, which they are leaving up to the industry because the Chinese are already too far behind," says Jun Ni, director of the Shien-Ming Manufacturing Research Center at the University of Michigan.


Buying Capability

Another strategy China's leaders are keenly supporting is out right acquisition of know-how. Chinese computer maker Lenovo's $1.75-billion purchase of IBM's PC business in December 2004 has been the most hyped of the deals, but many others have gone under the radar: electronics and electrical appliance maker TCL acquired 55% of mobile handset maker Alcatel for $55-million in 2004, while oil refiner Sinopec acquired U.S.-based First International Oil Corp. for $153 million in the same year. This trend is likely to continue as indicated in a May 2008 study by McKinsey in which 55% of Chinese executives polled said mergers and acquisitions were "at the heart" of their long-term global strategies going forward to gain skilled workers and grow their global footprint.


The Real World

Further diversification of the manufacturing base into more advanced technologies requires a new set of skills from China's labor force, which until now has built itself on a foundation of sweat equity. The country has taken steps to beef up its intellectual power. Each year, Chinese universities are graduating 600,000 engineers from four-year programs. Compare that with the 70,000 from U.S. schools, and you can get a sense of how serious the Chinese are about competing.

But the massive number of newly minted engineers masks a monumental problem for Chinese companies: a fundamental lack of real-world experience needed to compete on the global stage. Results from an April 2008 survey by McKinsey & Company of executives at Chinese companies show that 44% believe a systematic lack of managerial-level talent is preventing China from experiencing true global reach, while at the same time limiting expansion domestically. This is especially true at some of the major Chinese automotive OEMs: First Automotive Works, Shanghai Automotive Industry Corp. and Dongfeng Motor Corp.

"The domestic automakers have learned to carbon-copy engines and vehicles in some cases, but moving to the next level of innovation is becoming the real challenge. They are trying to tap into the global expertise of engineering firms for help. Although you do have to wonder how long it's going to take them to overcome this deficit and my guess is not very long," says Bruce Belzowski, assistant research scientist at the automotive analysis division of the University of Michigan's Transportation Research Institute.

Most multinational corporations that have set up operations in China were required by the government to establish research and development facilities alongside their manufacturing operations to help build the country's technical know-how. Most observers point to General Motors' Pan Asian Automotive Technical Center (see "GM Excels in China") as an effective demonstration of how an automaker can build and leverage Chinese human resources for the benefit of its global operations. What GM has accomplished is rare, according to Loren Brandt, professor at the department of economics at the University of Toronto: "I commonly refer to most of these facilities as ‘PR&D'"-as in "Public Relations"-"because they are more for cosmetic reasons and sometimes what goes on there is superficial." But not always.


Design Challenges

China also finds itself lagging behind the rest of the world when it comes to product design and innovation. Fu Li-Chih, a graduate of California's Art Center and the first design director for Nanjing Automotive Corp., acknowledges the industry is "hesitant" when it comes to thinking outside-the-box to develop innovative vehicle designs; his role is to change that mindset. "The Central Government wants the industry to have some confidence to develop something that defines Chinese vehicle design," he says. Getting there will take a huge cultural change as evidenced by a study by Accenture wherein 64% of the more than 80 senior executives at Chinese companies indicated their organizations are "risk-averse." Li-Chih thinks Chinese automakers could succeed by taking baby steps to develop designs that are "subconscious" in their projection of Chinese culture: "Chinese design will be defined by that little twist, that minute-I would say 20%-difference that makes the vehicle stand out from the rest. If you can capture that 20%, you can make a difference and capture the youth market in China."

Ford and General Motors have taken steps to boost their Chinese design capabilities; this is benefitting domestic Chinese auto companies, experts say. GM is giving its Chinese studios a lead role in developing future designs for its Buick brand, as evidenced by the new Chinese-market Buick LaCrosse and Park Avenue, both of which were designed in Shanghai. GM's China team was also responsible for designing two recent concept cars, the Buick Invicta and Riviera. Ford's China design team-headed by Chelsia Lau-is putting its own spin on the upcoming Ford Fiesta: "The Fiesta five-door has been tailored for the China market and will be the best example of showcasing our global product strategy," explains Lau. "China is a critical market for our global success and our Chinese design operation plays an integral part of our global operating strategy. Our design approach in China follows the same global process of design and discipline for the company, just as our other design centers do around the world."


Improving Manufacturing Quality

China is also beginning to realize that it needs to rely on much more than just low labor costs to succeed on the manufacturing side of business. Other low-cost emerging countries-most notably Taiwan, Vietnam and South Africa-are putting pressures on Chinese manufacturers to embrace a more complicated strategy: improved quality and efficiency. Optimization of manufacturing efficiencies will be at the forefront of concerns for Chinese OEMs and multinationals operating there. A study by McKinsey suggests multinational companies with Chinese facilities could cut their operating costs there by around 15%, with revenues increasing 30%, through the institution of more efficient manufacturing processes. Some companies have implemented their global practices in China with great success. Alcoa, for example, introduced its Alcoa Business System at its Shanghai plant in 1998, and within six years lead times were cut by 30 to 50%, sales volumes doubled, and inventory levels fell. GM, which began manufacturing in China in 1997, runs its operations under the same global quality standards as its other facilities; its Chinese plants have even surpassed the quality levels achieved at some North American facilities.

While multinationals may be making inroads in making their Chinese manufacturing operations globally competitive, domestic producers are lagging far behind. The 2006 J.D. Power and Associates Chinese Initial Quality Study shows Chinese domestic automotive OEMs averaging 368 problems per 100 vehicles, nearly three-times those reported from global manufacturers in the comparable U.S. study. This doesn't mean Chinese OEMs aren't trying to narrow the gap, according to Paul Gao, a principle at McKinsey's Shanghai office: "One Chinese carmaker we studied had a seemingly robust and well-documented quality-gate system to catch defects during product development. Although the system detected problems adequately, many errors went unfixed, largely because of poor collaboration within the company and intense pressure to deliver products quickly."

In an effort to thwart further damage to China's already precarious product quality image in the critical auto sector, the Central Government has taken steps to assure inferior automobiles are not exported through the requirement of export certification. "They have instituted this to discourage substandard brands from exporting so they could better control quality and help keep the country from getting a black eye," says the University of Michigan's Belzowski.


Source of the Black Eye: Suppliers

Most of the problems relating to product quality can be traced back to China's component supply base, especially the sub-tiers. Major tier-one suppliers operate their Chinese facilities at world-class quality levels, but the second-and third-tier producers are a major source of quality issues. "The problem is you don't get the right materials in certain regions of the country and the same type of manufacturing techniques are not used everywhere," says Boston Consulting's Mosquet.

Several OEMs have already adopted supplier quality development programs that include six-month quality audits, adherence to strict working conditions, quality training sessions for supplier managers, and developing systems that will identify ways to rapidly resolve issues. "We're seeing the need, particularly from the multinationals, to increase local content to lower their overall costs. But there has to be a policy determined by the tier-one or OEM as to their definition of quality," says University of Toronto's Brandt. He points to a study he conducted comparing defect rates on certain components produced by tier-two suppliers in 2003 and 2006. The study showed the average defect rate at an exhaust system supplier dropped to 158.5 parts per million (ppm) from 634.5; a brake system supplier saw its ppm rate drop from 87.5 to 67.5, while a seat system supplier saw defects drop from 543 ppm to 142.75 ppm. Brandt's team discovered that most of these improvements came as a result of OEMs and tier-ones working directly to improve quality performance.

Finding and maintaining high-quality sub-tier suppliers is getting even more complicated because of rising domestic vehicle demand. Chinese OEMs are running at a torrid pace as demand remains strong from the domestic market. This is resulting in some suppliers refusing business from new customers, according to Boston Consulting's Mosquet. He says OEMs and tier-one suppliers are likely to find themselves cultivating new suppliers from the ground-up for certain components. That could delay vehicle and component launch plans, adding strain to an already stretched local management.


Moving Forward, Staying Put

China isn't likely to slow down as the rest of the world falls into the economic doldrums created by the weakening U.S. economy. According to the International Monetary Fund, China should post a 9% growth rate, marking the first time in more than five years the economy has grown less than 10%. Looking beyond the near-term, China's economy is expected to continue on its growth path, albeit at a more reasonable pace. Global Insight projects China's GDP will grow an average of 7.1% through 2025, while the U.S. economy will chug along at a 3% growth rate. This puts China on a path to surpass the U.S. as the world's largest economy by 2013, at the earliest. The Chinese government expects there to be 140-million cars on China's roads by the year 2020-nearly seven times the current level. The number of cars sold annually is expected to skyrocket to 20.6-million units in the same timeframe. China could surpass the U.S. in annual vehicle sales by as early as 2015, according to Lowell Paddock, vice president of planning-GM Asia Pacific. Ironically, growth is expected to push vehicle prices lower-average vehicle prices fell by 40% between 2001 and 2006 and are expected to fall another 15% by the end of this year-as a result of growing competition.


Coming to America?

Strong demand will likely force Chinese OEMs to focus attention on their home market, with plans for vehicle exports to remain at relatively small volumes, if any. "The Chinese OEMs who had plans to export to the U.S. market are pushing those plans back because the local market is growing at such a speed," says Boston Consulting's Mosquet, who adds, "As long as the Chinese market continues to grow; it will be more important and prudent for them to keep their focus on their home market. There's no reason for a company to give up on a market growing at a 20% annual rate and shift to investing in the U.S., which is in decline."

"If they come to the U.S. it will be in relatively small volumes because they do not have a distribution network built up, and that will have to be done before they arrive," says the University of Michigan's Belzowski. Chrysler set the first opportunity for Chinese automakers to enter the hyper-competitive U.S. market in January 2007, when it announced plans to partner with Chery Automobile to produce and engineer a B-segment car for the U.S. Quality issues have pushed back the program, which remains in the development stages. However, the automaker also signed a memorandum of understanding with Great Wall Motor Co. to explore long-term business ties surrounding distribution, technology and component activities. Experts believe these business models will likely be used as the template for Chinese OEMs to approach other U.S. automakers to utilize China's low cost structure to enter the U.S. auto market. First Auto Works has announced plans to export vehicles into Mexico, along with construction of a small-volume plant there country by 2010.


Turn About

The growing Chinese market also presents an opportunity for U.S. automakers to expand their presence in there through vehicle imports. This prospect was made easier when China agreed to cut its 28% tariff on vehicle imports to 10% as part of an agreement with the World Trade Organization. The China Trading Center for Automobile Import said it expects 360,000 vehicles to enter the country in 2008, a 20% increase over 2007. In June 2008, U.S. automakers reached an agreement with the Chinese government to import $2.2-billion worth of vehicles and components into the country over the next two years-GM will export product valued at $1-billion, including Cadillac models; Ford will export more than $800-million worth of products, including 30,000 North American-built vehicles and transmissions; Chrysler will ship more than $400-million worth of Jeep brand SUVs into the country. The U.S. Congressional Research Service predicts China could replace Japan as the third largest U.S. export market by the end of 2008.