Surging domestic demand has driven the development of China's auto industry at a dizzying pace in recent years, but the industry faces a probable shakeout because of over-investment and the market opening necessitated by membership in the World Trade Organization (WTO).

The industry's total output has been expanding at an annual clip of around 30% over the past several years, soaring from 1.8 million units in 1999 to 3.2 million units in 2002 and 4 million last year. The 2003 figure includes 1.97 million sedans, with the remainder consisting of trucks, buses, and commercial vehicles. With surging demand for sedans among Chinese citizens in keeping with the marked improvement of their living standards—especially those residing in cities—the ratio of total output made up of sedans is expected to grow to 60% within a few years.

China's auto market is now the third largest in the world, its auto production fourth largest, and there is no end in sight. The State Council predicts that production value will rise 25% this year to 1,460 billion renminbi (RMB). The industry now employs 2 million people; when those indirectly employed in peripheral sectors are included, the number reaches 14 million.

The vigorous development is being spurred with vigorous promotion by the Chinese government, which ranks auto manufacturing ahead of even the real-estate industry in importance. One example of this promotion is the US$1.3 billion that the central government injected into the industry during its Ninth Five-year Development Plan, covering 1996 to 2000.

Heavy market protection has enabled Chinese automakers to realize fat profit margins of about 22%, compared with just 3-5% in the industrially developed nations.

To achieve economies of scale, the Chinese government has been focusing its auto-industry support on the country's three leading automakers: First Automotive Works, Shanghai Automotive Industry Corp., and Dongfeng Motor Co.

Ambitious Targets

The big three together accounted for 48% of China's total auto production in 2003, turning out 2.1 million units. Their share of sedan production was an even higher 70%, with 1.38 million units. Each of the three is targeting 1 million units in 2004, and they hope to evolve into world-class carmakers within the next few years.

For example, First Automotive aims to boost its 2001 production number of 400,000 units fivefold within five to eight years, to 2 million units. To increase its production, Dongfeng has signed a 17 billion RMB joint-venture agreement with Nissan.

The big players, however, face intense competition from a large number of other entrants that have been attracted by the huge potential of China's market. The country now has a total of 130 auto plants, including those that have been established by 23 municipalities. Provincial governments are in the industry too, operating Beijing Automotive, South Automotive, Guangdong Automotive, and Fujian Automotive.

Most of the leading international auto brands have also joined the China competition, and have entered into joint-venture arrangements with major local manufacturers, which rely on them for production know-how. The foreign participants introduce new models in China almost simultaneously with their appearance in other markets.

The hundreds of billions of RMB that have been pumped into the industry in recent years has given rise to worries about excessive investment. The country's total auto-production capacity will reach an estimated 6.3 million units next year, while demand will be only about 5 million.

The supply glut will be made worse by the market-opening measures to be instituted over the next several years as a results of China's WTO commitments. Tariffs on automobiles with engine displacements under 3,000cc, for instance, will be cut from 38.2% to 34.2% this year, and those on autos with engines larger than 3,000cc will drop from 43% to 37.6%. The average tariff on autos will drop further on July 1, 2006, to 25%; and the average tariff on auto parts, now as high as 50%, will plunge to 10% at the same time. Non-tariff barriers such as quotas and licensing will be lifted on the first day of next year.

This will bring tougher competition for domestically made automobiles as imported cars, the quantity of which has already been growing rapidly (in the first half of 2003 it soared 74%, to 90,000 units), flood into the market in ever-greater numbers. Domestic manufacturers will have to slash their prices to remain competitive.

Lots of Problems

Other concerns include an over-reliance on foreign technology and the lack of home-grown brands, factors which cast shadows on the industry's long-term development in China. In many cases, the joint-venture agreements with foreign automakers allow the Chinese partners only to assemble automobiles using imported knock-down parts. Only a small number of the smaller producers are currently pushing their own brands, either buying technology from abroad or commissioning foreign companies to design new models for them. A few are trying to build up their own technological competence by participating in the development of new models by their foreign partners.

A lack of supporting industries such as those supplying steel parts, electronic devices, and molds is yet another worry.

The increasing competition will surely lead to the elimination of many Chinese automakers in the coming years, resulting in a slimmer but healthier industry. The survivors will be, of course, those that are relatively strong in finance, marketing, and technology.

Industry insiders suggest that Chinese car producers should find outlets for their excess capacity by developing overseas markets--especially Asian ones, such as Vietnam, that are not yet dominated by Japanese and South Korean models. Africa is another potential market. Although still small, Chinese auto exports have in fact been growing rapidly in recent years; in the first half of 2003 they skyrocketed 130%, to 41,000 units.

Despite all the problems it faces, the outlook for China's auto industry is bright, largely because of the huge domestic demand. An estimated 20% of the country's urban families, a total of 26.3 million households, now have the wherewithal to buy a car, either with cash or on credit. Auto ownership is expected to top 100 million within 10 years, up from just 10 million today. As a result, some observers are predicting that the country's auto market will grow to 10 million units annually within 10 years.