Loren Brandt & Johannes Van Biesebroeck

University of Toronto

4
Capability Building in China’s Auto
Supply Chains

ABSTRACT

W 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.

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MAIN FINDINGS

I 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

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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

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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

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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.

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BACKGROUND ON THE PROJECT

O 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.

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• 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.

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WHAT DRIVES CHANGE IN CHINA’S AUTO SECTOR

T HERE ARE FOUR KEY FACTORS

the following:
driving change in China; these include

• 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.

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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

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FIGURE 1
SHARE OF WORLD MOTOR VEHICLE PRODUCTION

Other, 23.3%

Europe, 30.7%

Canada, 3.9%

China, 8.3%

USA, 17.7%
Japan, 15.9%

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.

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FIGURE 2
BREAKDOWN OF MOTOR VEHICLE PRODUCTION

100%

80%

60%
Passenger
Buses
40% Trucks

20%

0%
1995 1997 1999 2001 2003 2005

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.

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FIGURE 3
VEHICLE TARIFF RATES

120

100
Tariff Rate (Percent)

80

Less than 3L
60
3L and up

40

20

0 .1
20 .1
01

04
98

00

02

03

05

.7
.1
20

20
19

20

20

20

20

06
06
20

Year

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.

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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)

Market Share
Firm Type Sales
(%)
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

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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
10
Change in Vehicle Price (Percent)
-30 -20 -10
-40 0

2001 2002 2003 2004 2005

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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.

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FIGURE 5
GROWTH IN CHINA’S VEHICLE PARTS SECTOR

450000 6000

400000
5000
350000
Sales (mn RMB)

300000 4000

250000 Total Revenue (Million RMB)

3000
200000 Number of Firms

150000 2000

100000
1000
50000

0 0
1998 1999 2000 2001 2002 2003 2004 2005
Year

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TABLE 3
NUMBER OF FIRMS IN CHINA’S VEHICLE PARTS AND COMPONENTS
SECTOR

1998 1999 2000 2001 2002 2003 2004 2005

Total
2320 2349 2496 2724 2968 3605 5625 5604
Number
FIE
288 333 402 466 541 675 1175 1225
of which:
71 92 108 148 198 284 571 614
WOS
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.

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 TABLE 4
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BRANDT & VAN BIESEBROECK

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
4-19

TABLE 5
EXPORT RATIOS AND CONTRIBUTION TO TOTAL EXPORTS, BY OWNERSHIP

1998 1999 2000 2001 2002 2003 2004 2005

CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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: 19.27 21.13 22.86 17.71 17.75 15.95 NA 19.63

WOS 76.46 69.77 61.43 38.8 36.26 27.81 NA 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: 64.21 68.13 71.22 65.58 64.67 58.81 NA 62.16

WOS 35.11 39.3 38.18 38.28 38.6 31.16 NA 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.
BRANDT & VAN BIESEBROECK

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.

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

FIGURE 6
IMPORTED PARTS AND COMPONENTS

6 2500
Number of vehicles (millions)

5
2000

4
1500 Number of Vehicles
vehicles produced
Produced

$US
3
Imported parts
Parts and engines
Engines per
1000 vehicle
Per Vehicle
2

500
1

0 0
03
95
96
97

98
99

00
01
02

04
05
20
19
19
19

19
19

20
20
20

20
20

Year

FIGURE 7
IMPORTS OF ENGINES

4-21
BRANDT & VAN BIESEBROECK

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

14000

12000

10000

Exports of Parts and

$US (000)

8000
Components
Imports of Parts and
6000
Components

4000

2000

0
1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005
Year

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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 0.143 0.143 0.143 0.151 0.156 0.149 0.107 0.094
of which:
WOS 0.103 0.117 0.13 0.161 0.148 0.137 0.096 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.

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BRANDT & VAN BIESEBROECK

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

1998 2005
.3
.2
Fraction
.1
0

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

Profit Rate
Graphs by year

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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

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BRANDT & VAN BIESEBROECK

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.

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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.

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BRANDT & VAN BIESEBROECK

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.

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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
# of Suppliers

60
50
40 China
30
20 India
10
0
0
1 0 pm

-2 00
>2 00
00
-3 0
-7 0
- 1 00
-1 0
30

50
00
0

50
20
50
0
-7
0p
0-
0
<1

Defect Rates: PPM

4-29
BRANDT & VAN BIESEBROECK

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.

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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 158.5 634.5 1070 1967.5 67.5 87.5 142.75
PPM

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.

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BRANDT & VAN BIESEBROECK

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

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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.

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BRANDT & VAN BIESEBROECK

TABLE 8
SOURCING BY OEMS IN CHINA (% OF 1ST TIER SUPPLIERS)

Overseas
OEM JV/WOS Domestic
(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 69.7 15.4 14.5

(non-Chinese OEMs)

Average 39.2 60.8 0

(Chinese OEMs)

Average (all) 62.9 25.5 11.3

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 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

SOME POTENTIAL IMPLICATIONS FOR OVERSEAS PART

SUPPLIERS

D 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

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BRANDT & VAN BIESEBROECK

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)

5000

4000

3000

1995
$US, million

2000 2000
2005
1000

0
TA

a
n

er
pe

st
)

ric
er
pa

ic

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4-36
 CAPABILITY BUILDING IN CHINA’S AUTO SUPPLY CHAINS

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:
ƒ World-class production quality at lowest cost
ƒ World-class design and redesign capabilities
ƒ 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.

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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.

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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.

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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

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