Under the Hood

Auto component suppliers in China ride a fast but rough road

by James A. C. Sinclair

China's auto sector growth has captured the world's attention. In 2003, the nation's total auto output grew 35 percent to 4.4 million and passenger car output grew an astonishing 83 percent to 2 million. And despite a slowdown in auto sales growth to 15 percent in 2004, automakers remain committed to their strategic positions, with General Motors Corp. (GM), Volkswagen AG (VW), Ford Motor Co., and Toyota Motor Corp. planning to invest a total of more than $12 billion over the next five years.

As global automakers have scrambled to enter the China market, so have their component suppliers. Roughly 800 foreign auto component suppliers currently operate in mainland China, and these include most of the top 50 multinationals. Aktiebolaget SKF of Sweden; Cummins, Inc., Delphi Corp., Eaton Corp., ITT Industries, Inc., and Visteon Corp. of the United States; Denso Corp. of Japan; and Robert Bosch GmbH, Siemens VDO AG, and ZF Friedrichshafen AG of Germany, to name a few, all have several production facilities in China.

Despite the impressive growth of the sector, the presence of major foreign manufacturers, and the shift of auto sector practices and expectations toward more international norms, operational risks for foreign auto component suppliers remain substantial. Auto component suppliers that are not already present in China must carefully consider their market entry strategies, and suppliers that already have a presence must determine the best way to move forward.

In need of a tune-up

Despite the rapid growth and influx of foreign investment, China's auto component sector remains poorly structured, relatively protected, and technically weak. The sector suffers from several problems:

Too many automakers
The auto component sector's problems begin with China's automakers. At the end of 2004, there were 33 passenger car manufacturers in China, with an average output of only 70,000 units per manufacturer. Even joint venture (JV) automakers have relatively limited capacities of 100,000 to 250,000 units, and only Shanghai VW, a JV between the Shanghai Automotive Industry Corp. and VW, has a capacity of more than 300,000. (More sizeable US or EU plants average 300,000-400,000 units per year.) Plants are scattered across China: Beijing; Changchun, Jilin; Chongqing; Fuzhou, Fujian; Guangzhou; Nanjing, Jiangsu; Ningbo, Zhejiang; Shanghai; Shenyang, Liaoning; Tianjin; Wuhan, Hubei; and Wuhu, Anhui.
Too many component suppliers
Though the automaker sector is fragmented, the auto component sector is even worse. According to official statistics, China had 4,833 auto component suppliers by the end of 2004 with combined revenues of ¥382 billion ($46.1 billion).
Scattered supply bases
Chinese automakers have encouraged auto component suppliers to locate nearby to maintain self-sufficiency. Thus, auto component suppliers are as scattered around the country as auto firms. Sustained by local and group protectionism, the cluster pattern is likely to continue because of the need for just-in-time supply deliveries. JV automakers in particular now require some components to be delivered to their factories several times per day, and because of inefficiencies in China's logistics infrastructure, this is only possible if the component supplier has a factory or warehouse near its client's assembly lines.
Small-scale operations duplicate efforts
Because of the scattered supply base, dozens of auto component suppliers manufacture the same components in China. For example, automakers can choose from among 27 manufacturers of shock absorbers and 23 manufacturers of steering gears. Many component suppliers in China thus operate below capacity and have been unable to achieve large production scales or efficient economies of scale. Consider that Toyoda Gosei Co., Ltd., a component supplier ranked 50th in the world, had net sales in 2001 greater than the combined total of China's top 10 auto component suppliers.
Supply chain lacks clear hierarchy
The auto component sector in China also lacks the hierarchy (the clearly structured tiers of the auto component value chain that start with raw material producers and end with automakers) that is the backbone of the global auto industry. Tier 1 suppliers (which primarily sell to automakers) and Tier 2 suppliers (which primarily sell to Tier 1 suppliers) are not clearly distinguishable, and therefore automakers have to deal with both Tier 1 and Tier 2 suppliers, often amounting to several hundred in number. Supply chain management clearly costs automakers in China a lot of time and money.
JV automakers are ramping up pressure on auto component supply chains in China, with almost all the automakers implementing price reduction requirements of 3 to 10 percent per year, and subjecting the auto component suppliers to an unprecedented margin squeeze.

Protectionism persists
Although local content requirements have officially been abolished, the new Automotive Industry Development Policy, which took effect June 2004, appears to push indirectly for localization; Customs can now impose higher import duties on knock-down kits if automakers fail to meet the new policy's vague requirements of "complete vehicle characteristics."
Moreover, the culture of protectionism still prevails in the auto sector—at the national, provincial, and local levels. Since around 70 percent of Chinese auto component suppliers remain fully or partially owned by Chinese automakers, local protectionism has also combined with a culture of group protectionism. For products other than those strictly controlled by the foreign partner, protectionism has led to local or subsidiary suppliers securing orders despite the fact that they offer inferior components at higher prices. Some Chinese automakers declare that, everything being equal, they first select the group member, then the supplier located closest to their assembly lines, then finally suppliers outside of their network. But "everything being equal" is just a smokescreen. Even among JVs, protectionism remains strong—and can even be strongest at older JV automakers such as Shanghai VW and First Auto Works VW. Chinese partners will often select an inefficient local Chinese supplier that is a member of their group rather than an efficient supplier outside of the group. Indeed, the Chinese party and the foreign party often have different objectives for establishing and managing their supply chains.
Entrenchment blocks market entry and expansion of new firms
The entrenchment of local and group suppliers has been exacerbated by the strong role that personal relationships play within the supply chain. Because automakers have several departments involved in supplier selection (such as product development, quality control, and purchasing departments), auto component suppliers must establish and maintain multiple personal relationships with each automaker. Supplier selection is a resource-intensive process, often involving underhanded dealings, and has acted as a barrier to market entry and expansion. While homologation (certification that confirms a product met required standards) in other markets, such as US or European markets, has allowed some foreign auto component suppliers to sell to JV automakers, the level of entrenchment makes it difficult for many newcomers to break into the market.
Technological weakness
Chinese auto component suppliers have been slow to invest in product development. Though they are adept at making prototypes based on blueprints or physical samples, most real product development remains in the hands of foreign auto component suppliers. JV automakers still must import components for newly introduced car models (such as the Audi A6, the BMW 3 and 5 series, and the Buick Regal) while the Chinese auto component suppliers play catch-up, and they will need to do so until the components become locally available.
Counterfeiting
Finally, many of the foreign auto component suppliers in China are facing a serious problem with intellectual property rights (IPR) infringement. According to a survey conducted by the Taiwan newspaper Commercial Times, 56 percent of all vehicles in China contain counterfeit components. One US auto company believes exports from China of counterfeit components for its cars may exceed $200 million per year. In raids of counterfeiting factories, the company has found fake transmission fluid, oil filters, and brake liners—all made of absurdly poor substitute materials. Though IPR infringement is widespread in China, it has a particularly large impact on the auto sector because of the sector's increasingly competitive price pressures, income loss through lost sales, and smaller economies of scale. Though the PRC central government has indicated that it will crack down more heavily on IPR infringers, provincial and municipal governments remain reluctant to close counterfeiters down, and seized goods are often returned to the market rather than destroyed.

Auto Components in Yongkang, Zhejiang

Yongkang, Zhejiang, is a major producer of auto components for the aftermarket in China and overseas. The city hosts roughly 10,000 manufacturers, and most makers offer products that are more attractive for their price than their quality. These manufacturers keep costs low using a range of methods:

Using labor-intensive rather than capital-intensive production methods;
Hiring temporary workers at ¥3-5 ($0.36-$0.60) per hour without any insurance or benefits;
Running workshops that are small, rundown, and without climate control;
Operating at night when electricity rates are discounted;
Sourcing the cheapest raw materials available, including scrap metal; and
"Shutting down" and re-registering to enjoy the tax holidays of "new" companies.

Many of these manufacturers do not even have a company nameplate at the front gate of their factories.

—James A. C. Sinclair

One Supplier, Multiple Plants

Many foreign auto component suppliers have set up multiple operations in China, with multinational corporations like Hella KgaA Hueck & Co., Lear Corp., and Visteon Corp. running about a dozen entities across the nation. Even smaller foreign auto component suppliers tend to run several entities that produce the same component in different locations.

—James A. C. Sinclair

Slowdown exposes weaknesses

Compared with the remarkable growth during 2003, sales growth in China's auto market slowed significantly in 2004, with sales of passenger cars growing only 15 percent, to 2.33 million vehicles. The central government instituted a number of macroeconomic measures that are partly responsible for the reduced pace, but the slowdown is also a reasonable market correction, shifting the explosive auto sales growth of the last two years toward a more sustainable pace.

Automakers in China have had to balance the risk of temporary overcapacity with the risk of losing potential sales, and overcapacity is the greater concern now. Automaker plant utilization dropped from 96 percent in 2003 to around 75 percent in 2004 and was even lower in plants that produce older models. In addition, automaker inventory levels more than doubled from 2003 to 2004. In this period of imbalance, the auto sector reached a crunch point, bringing sector weaknesses to the forefront.

Trends will upend the status quo

Now that players in China's auto sector have begun to understand the significance of these weaknesses better, there are signs that the auto component sector may be gradually streamlining in response.

From protectionism to competition
With a slowdown in passenger car sales and increasingly fierce competition in the sector, Chinese automakers can no longer afford to protect subsidiary or local suppliers. Thus, most of the major component subsidiaries are being restructured as independent companies charged with supplying the whole sector, thus exposing them to outside competition. Although intra-group trade may still account for most of their transactions, even these transactions are slowly becoming more market-oriented.

Cost pressures spark efficiency
The auto industry's large fixed costs and current overcapacity have forced automakers and component suppliers to focus on reducing costs. Despite low wages and weak environmental protection requirements, China's auto components have historically been relatively expensive, largely because of inefficient production and high profit margins. Now JV automakers are ramping up pressure on auto component supply chains in China, with almost all the automakers implementing price reduction requirements of 3 to 10 percent per year, and subjecting the auto component suppliers to an unprecedented margin squeeze.

Technological upgrades
JV automakers are actively encouraging suppliers to develop and upgrade the local supply base. On the one hand, this requires JV automakers to drag foreign component suppliers to China to establish local operations. On the other hand, it means supporting Chinese component suppliers by subsidizing their upfront tooling expenses for critical components. JV automakers are not just motivated by the potential for a cheaper supply base, but by the need for local product development as they start to redesign models specifically for the China market. The consequence for foreign component suppliers is that simply transferring production operations to China is no longer enough. (For example, in the redesign of the Buick Regal for the China market, GM worked with Visteon's local team on the development of the new dashboard module.)

Consolidation and sector cleanup
To meet these expectations and still make profits, the auto component sector must consolidate and restructure. A fight for survival lies ahead that will shake out weaker players, drive forward mergers and acquisitions, and result in fewer but stronger auto component suppliers. These suppliers will seek greater economies of scale, which are needed to sustain price competitiveness, resources to invest in product development, and ultimately long-term relationships with the automakers. Restructuring will also lead to more efficient auto component supply chains; strong sub-assemblers (producers of assembled units that make up components) will likely create a more typical first-tier structure in China. Within the next five years, the current 5,000 auto component suppliers will likely shrink to 1,000.

Component exports on the rise
Overseas markets are already feeling the growing strength of China's auto component suppliers. China's auto component exports grew 43 percent in 2004, to $7.38 billion, accounting for more than a fifth of China's total component production. China is strongest in tires, electronics and meters, shock absorbers, wheels and wheel parts, brakes and brake parts, and body parts. Though many of these exports are presently limited to the aftermarket (the market for replacement parts), as Chinese auto component suppliers upgrade technologies and strive for economies of scale, China will increasingly export to global automakers. GM and Ford Motor Co. have already announced that they intend to substantially increase their component purchases from China. (By 2010, GM plans to purchase components worth $10 billion, and Ford plans to purchase $7 billion.) As a result, exports from China will grow at an average of 25 to 30 percent per year over the coming five years.

Chinese suppliers invest overseas
Some of China's auto component suppliers have already gone a step further and made acquisitions overseas. The Wanxiang Group from Hangzhou, Zhejiang, has acquired 10 US auto component suppliers since 1995, looking to gain access to overseas markets. The Greencool Group from Shenzhen announced at the end of 2004 that it had acquired Gates Corp.'s hose plant in France and intends to transfer the technology back to China to begin exports of low-cost, high-quality industrial and auto hoses. More Chinese component suppliers will likely follow in their footsteps.

Difficult questions and operational risks remain

Though these new trends will bring marked improvements in the auto component sector, foreign auto component suppliers that wish to enter the sector still have to make tough decisions.

Relocate to China?
Though most multinational auto component suppliers are already in China, many smaller foreign players have yet to make the move. For some, China is seen as a great opportunity because it can serve as a low-cost production base for exports and because the country is an attractive market in itself. For other companies, it is more a question of whether they can afford not to come to China. All companies must weigh the risks—especially the auto sales slowdown and expected industry shakeout, in China and around the world.

Parameters for market entry
Foreign auto component suppliers that plan to enter China in 2005 will have to develop market entry strategies that can meet many challenges. Suppliers should consider, among other aspects of the market, the importance of homologation and dependence on imports; the competition, including competitors' consolidation levels and export strength; switching costs (customers' willingness to "switch" from existing suppliers in China to new suppliers), including protectionism and entrenchment; technology gaps, such as local quality levels and possible IPR infringements; and suitable partners, including their availability and interest level. Though market-entry strategies are company specific, these parameters may be applied to two variables: the selection of investment vehicle (whether a JV or a wholly foreign-owned enterprise) and sales orientation (whether domestic or foreign sales).

Choosing a JV partner
Despite the gradual weakening of protectionism and entrenchment in China's auto component sector, foreign component suppliers that plan to sell to the domestic market in the short term may still wish to partner with the subsidiary of a Chinese automaker. Such JV partners offer the advantages of market access, knowledge of local practices, and possibly low-cost production. But with so many foreign auto component suppliers making the move to China, most of the attractive Chinese partners have already been snapped up. The remaining firms are likely to offer only small market shares, of 5 percent or less, which hardly compensates for the normal risks associated with JVs.

With so many foreign auto component suppliers making the move to China, most of the attractive Chinese partners have already been snapped up.

Setting up in multiple locations
Since one JV partner can provide access to only one automaker, and because just-in-time supply delivery requires supply bases close to automaker assembly lines, foreign auto component suppliers that intend to expand in China still must establish entities in multiple locations. As market forces gradually make China's auto component sector more market oriented, and as ongoing investment in the logistics sector creates more delivery options, foreign auto component suppliers may start to consolidate their multiple operations and strive for better economies of scale in China.

Inevitable market entry?

This backdrop creates a market brimming with opportunities and risks. Auto component suppliers that are not yet in China will likely feel increasing pressure to make the move. Issues like multiple plant locations will remain significant challenges for smaller auto component suppliers that will have to struggle to achieve economies of scale and make profits, but these companies will likely need to deploy market entry strategies soon and accept a certain level of risk—or consider what their absence from China will mean for their future.

James A. C. Sinclair is senior consultant and head of Strategy at InterChina Consulting, Shanghai.

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	Under the Hood Auto component suppliers in China ride a fast but rough road by James A. C. Sinclair China's auto sector growth has captured the world's attention. In 2003, the nation's total auto output grew 35 percent to 4.4 million and passenger car output grew an astonishing 83 percent to 2 million. And despite a slowdown in auto sales growth to 15 percent in 2004, automakers remain committed to their strategic positions, with General Motors Corp. (GM), Volkswagen AG (VW), Ford Motor Co., and Toyota Motor Corp. planning to invest a total of more than $12 billion over the next five years. As global automakers have scrambled to enter the China market, so have their component suppliers. Roughly 800 foreign auto component suppliers currently operate in mainland China, and these include most of the top 50 multinationals. Aktiebolaget SKF of Sweden; Cummins, Inc., Delphi Corp., Eaton Corp., ITT Industries, Inc., and Visteon Corp. of the United States; Denso Corp. of Japan; and Robert Bosch GmbH, Siemens VDO AG, and ZF Friedrichshafen AG of Germany, to name a few, all have several production facilities in China. Despite the impressive growth of the sector, the presence of major foreign manufacturers, and the shift of auto sector practices and expectations toward more international norms, operational risks for foreign auto component suppliers remain substantial. Auto component suppliers that are not already present in China must carefully consider their market entry strategies, and suppliers that already have a presence must determine the best way to move forward. In need of a tune-up Despite the rapid growth and influx of foreign investment, China's auto component sector remains poorly structured, relatively protected, and technically weak. The sector suffers from several problems: Too many automakers The auto component sector's problems begin with China's automakers. At the end of 2004, there were 33 passenger car manufacturers in China, with an average output of only 70,000 units per manufacturer. Even joint venture (JV) automakers have relatively limited capacities of 100,000 to 250,000 units, and only Shanghai VW, a JV between the Shanghai Automotive Industry Corp. and VW, has a capacity of more than 300,000. (More sizeable US or EU plants average 300,000-400,000 units per year.) Plants are scattered across China: Beijing; Changchun, Jilin; Chongqing; Fuzhou, Fujian; Guangzhou; Nanjing, Jiangsu; Ningbo, Zhejiang; Shanghai; Shenyang, Liaoning; Tianjin; Wuhan, Hubei; and Wuhu, Anhui. Too many component suppliers Though the automaker sector is fragmented, the auto component sector is even worse. According to official statistics, China had 4,833 auto component suppliers by the end of 2004 with combined revenues of ¥382 billion ($46.1 billion). Scattered supply bases Chinese automakers have encouraged auto component suppliers to locate nearby to maintain self-sufficiency. Thus, auto component suppliers are as scattered around the country as auto firms. Sustained by local and group protectionism, the cluster pattern is likely to continue because of the need for just-in-time supply deliveries. JV automakers in particular now require some components to be delivered to their factories several times per day, and because of inefficiencies in China's logistics infrastructure, this is only possible if the component supplier has a factory or warehouse near its client's assembly lines. Small-scale operations duplicate efforts Because of the scattered supply base, dozens of auto component suppliers manufacture the same components in China. For example, automakers can choose from among 27 manufacturers of shock absorbers and 23 manufacturers of steering gears. Many component suppliers in China thus operate below capacity and have been unable to achieve large production scales or efficient economies of scale. Consider that Toyoda Gosei Co., Ltd., a component supplier ranked 50th in the world, had net sales in 2001 greater than the combined total of China's top 10 auto component suppliers. Supply chain lacks clear hierarchy The auto component sector in China also lacks the hierarchy (the clearly structured tiers of the auto component value chain that start with raw material producers and end with automakers) that is the backbone of the global auto industry. Tier 1 suppliers (which primarily sell to automakers) and Tier 2 suppliers (which primarily sell to Tier 1 suppliers) are not clearly distinguishable, and therefore automakers have to deal with both Tier 1 and Tier 2 suppliers, often amounting to several hundred in number. Supply chain management clearly costs automakers in China a lot of time and money. JV automakers are ramping up pressure on auto component supply chains in China, with almost all the automakers implementing price reduction requirements of 3 to 10 percent per year, and subjecting the auto component suppliers to an unprecedented margin squeeze. Protectionism persists Although local content requirements have officially been abolished, the new Automotive Industry Development Policy, which took effect June 2004, appears to push indirectly for localization; Customs can now impose higher import duties on knock-down kits if automakers fail to meet the new policy's vague requirements of "complete vehicle characteristics." Moreover, the culture of protectionism still prevails in the auto sector—at the national, provincial, and local levels. Since around 70 percent of Chinese auto component suppliers remain fully or partially owned by Chinese automakers, local protectionism has also combined with a culture of group protectionism. For products other than those strictly controlled by the foreign partner, protectionism has led to local or subsidiary suppliers securing orders despite the fact that they offer inferior components at higher prices. Some Chinese automakers declare that, everything being equal, they first select the group member, then the supplier located closest to their assembly lines, then finally suppliers outside of their network. But "everything being equal" is just a smokescreen. Even among JVs, protectionism remains strong—and can even be strongest at older JV automakers such as Shanghai VW and First Auto Works VW. Chinese partners will often select an inefficient local Chinese supplier that is a member of their group rather than an efficient supplier outside of the group. Indeed, the Chinese party and the foreign party often have different objectives for establishing and managing their supply chains. Entrenchment blocks market entry and expansion of new firms The entrenchment of local and group suppliers has been exacerbated by the strong role that personal relationships play within the supply chain. Because automakers have several departments involved in supplier selection (such as product development, quality control, and purchasing departments), auto component suppliers must establish and maintain multiple personal relationships with each automaker. Supplier selection is a resource-intensive process, often involving underhanded dealings, and has acted as a barrier to market entry and expansion. While homologation (certification that confirms a product met required standards) in other markets, such as US or European markets, has allowed some foreign auto component suppliers to sell to JV automakers, the level of entrenchment makes it difficult for many newcomers to break into the market. Technological weakness Chinese auto component suppliers have been slow to invest in product development. Though they are adept at making prototypes based on blueprints or physical samples, most real product development remains in the hands of foreign auto component suppliers. JV automakers still must import components for newly introduced car models (such as the Audi A6, the BMW 3 and 5 series, and the Buick Regal) while the Chinese auto component suppliers play catch-up, and they will need to do so until the components become locally available. Counterfeiting Finally, many of the foreign auto component suppliers in China are facing a serious problem with intellectual property rights (IPR) infringement. According to a survey conducted by the Taiwan newspaper Commercial Times, 56 percent of all vehicles in China contain counterfeit components. One US auto company believes exports from China of counterfeit components for its cars may exceed $200 million per year. In raids of counterfeiting factories, the company has found fake transmission fluid, oil filters, and brake liners—all made of absurdly poor substitute materials. Though IPR infringement is widespread in China, it has a particularly large impact on the auto sector because of the sector's increasingly competitive price pressures, income loss through lost sales, and smaller economies of scale. Though the PRC central government has indicated that it will crack down more heavily on IPR infringers, provincial and municipal governments remain reluctant to close counterfeiters down, and seized goods are often returned to the market rather than destroyed. Auto Components in Yongkang, Zhejiang Yongkang, Zhejiang, is a major producer of auto components for the aftermarket in China and overseas. The city hosts roughly 10,000 manufacturers, and most makers offer products that are more attractive for their price than their quality. These manufacturers keep costs low using a range of methods: Using labor-intensive rather than capital-intensive production methods; Hiring temporary workers at ¥3-5 ($0.36-$0.60) per hour without any insurance or benefits; Running workshops that are small, rundown, and without climate control; Operating at night when electricity rates are discounted; Sourcing the cheapest raw materials available, including scrap metal; and "Shutting down" and re-registering to enjoy the tax holidays of "new" companies. Many of these manufacturers do not even have a company nameplate at the front gate of their factories. —James A. C. Sinclair One Supplier, Multiple Plants Many foreign auto component suppliers have set up multiple operations in China, with multinational corporations like Hella KgaA Hueck & Co., Lear Corp., and Visteon Corp. running about a dozen entities across the nation. Even smaller foreign auto component suppliers tend to run several entities that produce the same component in different locations. —James A. C. Sinclair Slowdown exposes weaknesses Compared with the remarkable growth during 2003, sales growth in China's auto market slowed significantly in 2004, with sales of passenger cars growing only 15 percent, to 2.33 million vehicles. The central government instituted a number of macroeconomic measures that are partly responsible for the reduced pace, but the slowdown is also a reasonable market correction, shifting the explosive auto sales growth of the last two years toward a more sustainable pace. Automakers in China have had to balance the risk of temporary overcapacity with the risk of losing potential sales, and overcapacity is the greater concern now. Automaker plant utilization dropped from 96 percent in 2003 to around 75 percent in 2004 and was even lower in plants that produce older models. In addition, automaker inventory levels more than doubled from 2003 to 2004. In this period of imbalance, the auto sector reached a crunch point, bringing sector weaknesses to the forefront. Trends will upend the status quo Now that players in China's auto sector have begun to understand the significance of these weaknesses better, there are signs that the auto component sector may be gradually streamlining in response. From protectionism to competition With a slowdown in passenger car sales and increasingly fierce competition in the sector, Chinese automakers can no longer afford to protect subsidiary or local suppliers. Thus, most of the major component subsidiaries are being restructured as independent companies charged with supplying the whole sector, thus exposing them to outside competition. Although intra-group trade may still account for most of their transactions, even these transactions are slowly becoming more market-oriented. Cost pressures spark efficiency The auto industry's large fixed costs and current overcapacity have forced automakers and component suppliers to focus on reducing costs. Despite low wages and weak environmental protection requirements, China's auto components have historically been relatively expensive, largely because of inefficient production and high profit margins. Now JV automakers are ramping up pressure on auto component supply chains in China, with almost all the automakers implementing price reduction requirements of 3 to 10 percent per year, and subjecting the auto component suppliers to an unprecedented margin squeeze. Technological upgrades JV automakers are actively encouraging suppliers to develop and upgrade the local supply base. On the one hand, this requires JV automakers to drag foreign component suppliers to China to establish local operations. On the other hand, it means supporting Chinese component suppliers by subsidizing their upfront tooling expenses for critical components. JV automakers are not just motivated by the potential for a cheaper supply base, but by the need for local product development as they start to redesign models specifically for the China market. The consequence for foreign component suppliers is that simply transferring production operations to China is no longer enough. (For example, in the redesign of the Buick Regal for the China market, GM worked with Visteon's local team on the development of the new dashboard module.) Consolidation and sector cleanup To meet these expectations and still make profits, the auto component sector must consolidate and restructure. A fight for survival lies ahead that will shake out weaker players, drive forward mergers and acquisitions, and result in fewer but stronger auto component suppliers. These suppliers will seek greater economies of scale, which are needed to sustain price competitiveness, resources to invest in product development, and ultimately long-term relationships with the automakers. Restructuring will also lead to more efficient auto component supply chains; strong sub-assemblers (producers of assembled units that make up components) will likely create a more typical first-tier structure in China. Within the next five years, the current 5,000 auto component suppliers will likely shrink to 1,000. Component exports on the rise Overseas markets are already feeling the growing strength of China's auto component suppliers. China's auto component exports grew 43 percent in 2004, to $7.38 billion, accounting for more than a fifth of China's total component production. China is strongest in tires, electronics and meters, shock absorbers, wheels and wheel parts, brakes and brake parts, and body parts. Though many of these exports are presently limited to the aftermarket (the market for replacement parts), as Chinese auto component suppliers upgrade technologies and strive for economies of scale, China will increasingly export to global automakers. GM and Ford Motor Co. have already announced that they intend to substantially increase their component purchases from China. (By 2010, GM plans to purchase components worth $10 billion, and Ford plans to purchase $7 billion.) As a result, exports from China will grow at an average of 25 to 30 percent per year over the coming five years. Chinese suppliers invest overseas Some of China's auto component suppliers have already gone a step further and made acquisitions overseas. The Wanxiang Group from Hangzhou, Zhejiang, has acquired 10 US auto component suppliers since 1995, looking to gain access to overseas markets. The Greencool Group from Shenzhen announced at the end of 2004 that it had acquired Gates Corp.'s hose plant in France and intends to transfer the technology back to China to begin exports of low-cost, high-quality industrial and auto hoses. More Chinese component suppliers will likely follow in their footsteps. Difficult questions and operational risks remain Though these new trends will bring marked improvements in the auto component sector, foreign auto component suppliers that wish to enter the sector still have to make tough decisions. Relocate to China? Though most multinational auto component suppliers are already in China, many smaller foreign players have yet to make the move. For some, China is seen as a great opportunity because it can serve as a low-cost production base for exports and because the country is an attractive market in itself. For other companies, it is more a question of whether they can afford not to come to China. All companies must weigh the risks—especially the auto sales slowdown and expected industry shakeout, in China and around the world. Parameters for market entry Foreign auto component suppliers that plan to enter China in 2005 will have to develop market entry strategies that can meet many challenges. Suppliers should consider, among other aspects of the market, the importance of homologation and dependence on imports; the competition, including competitors' consolidation levels and export strength; switching costs (customers' willingness to "switch" from existing suppliers in China to new suppliers), including protectionism and entrenchment; technology gaps, such as local quality levels and possible IPR infringements; and suitable partners, including their availability and interest level. Though market-entry strategies are company specific, these parameters may be applied to two variables: the selection of investment vehicle (whether a JV or a wholly foreign-owned enterprise) and sales orientation (whether domestic or foreign sales). Choosing a JV partner Despite the gradual weakening of protectionism and entrenchment in China's auto component sector, foreign component suppliers that plan to sell to the domestic market in the short term may still wish to partner with the subsidiary of a Chinese automaker. Such JV partners offer the advantages of market access, knowledge of local practices, and possibly low-cost production. But with so many foreign auto component suppliers making the move to China, most of the attractive Chinese partners have already been snapped up. The remaining firms are likely to offer only small market shares, of 5 percent or less, which hardly compensates for the normal risks associated with JVs. With so many foreign auto component suppliers making the move to China, most of the attractive Chinese partners have already been snapped up. Setting up in multiple locations Since one JV partner can provide access to only one automaker, and because just-in-time supply delivery requires supply bases close to automaker assembly lines, foreign auto component suppliers that intend to expand in China still must establish entities in multiple locations. As market forces gradually make China's auto component sector more market oriented, and as ongoing investment in the logistics sector creates more delivery options, foreign auto component suppliers may start to consolidate their multiple operations and strive for better economies of scale in China. Inevitable market entry? This backdrop creates a market brimming with opportunities and risks. Auto component suppliers that are not yet in China will likely feel increasing pressure to make the move. Issues like multiple plant locations will remain significant challenges for smaller auto component suppliers that will have to struggle to achieve economies of scale and make profits, but these companies will likely need to deploy market entry strategies soon and accept a certain level of risk—or consider what their absence from China will mean for their future. James A. C. Sinclair is senior consultant and head of Strategy at InterChina Consulting, Shanghai. Top of Page Table of Contents
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