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Thesis Chapter 2 on Linkages Between Foreign Affiliates and Domestic Firms in Chinese Automobile Industry

(4302 words)

The success story of China rested on two factors: the opening-up of the economy drove foreign investment into an escalating quantity and; the enormous export industry developed from the local and foreign industries. Thus, the spillover effect of this development reaches even the Chinese automobile industry. Consequently, this is a major shift from the poverty-stricken and populous country, previously portrayed in the literature, to a robust and competitive economic power that it truly is.

            Interestingly however, the reliance of the Chinese economy in foreign capital and technology poses some concerns on the future of China’s national automobile industry. In the process of the foreign automobile buildup, the domestic firms are left with two options: to lag behind or to utilize the technological and capital opportunities to its advantage. This dilemma concerns even the government. In the past years, we saw several policy programs instituted in order to help in the development in the auto industry. This policies are instrumental in shaping and eventually, taking control of the auto industry that has been increasingly dependent on foreign firms.

1.1         Chinese Auto Industry

The Chinese automobile industry is the backbone of the national economy. It created work opportunities and developed the immense economic and human resource potential that significantly altered the development patterns in the China. Moreover, it is playing a major role in the development of national economy and improvement of people’s standard of living.

While China is changing from the command to market economy, both the central and provincial governments are still using the management of the center-periphery relations as the principal tool for managing this transition. China at times faces more restraints, being a weaker partner in its rapidly emerging global linkages. This has resulted in greater policy ambivalence and contradictions. As the experience in the automobile industry suggests, China relies on cross-border partnerships to obtain the foreign capital and technology needed for introducing new products and modernizing the production process. For this reason, China has sometimes to allow the local decision units to retain more policy autonomy. It has also to retreat from disallowing the foreign partners access to the Chinese partners’ domestic market. The process of globalization in the automobile industry and accompanying global linkages has also begun to restructure the manufacturer-supplier relations in the Chinese auto industry.

Foreign new product and new technology and foreign & Hong Kong, Macao, Taiwan investment have been introduced into China since the policy of opening-up and reform was adopted. They are very important on the technical reform and structural restructuring of manufacturers in the industry. The industry is catching up with international market with a rapid development speed. At present, certain production size and economic basis have been formed in the industry. In 1999, the total automobile output in China was more than 1,835,000 units within which there were more than 150 basic automobile types such as lorry, passenger car and limousine, go-anywhere vehicle, dumpcart and tractor. There are more than 1000 kinds of professional automobiles such as van, lorries for storage, dumpcart for mining, and automobiles for special use. In terms of total automobile output and its rank of China was the 10th and 14th in the world. In 1998 the value of production in automobile industry was RMB298.731 billion, accounted for 3.76% of GDP. The production volume and production quality was 12.3 times and 38.4 times as much as that in 1978 respectively at the beginning of opening-up and reform. There are 2426 manufacturers in the industry within which there are 115 automobile manufacturers, 525 installation and changing manufacturers and 10 motor manufacturers. There are 196,283 employees. The total values of fixed assets are RMB22.2236 billion. The automobile industry occupies an important place in the whole national economy.

Attracting foreign linkages have been an integral part of China’s overall economic reform strategy since the initiation of the market reform in the late 1970’s.  The law on Sino-Foreign Equity Joint Ventures promulgated in July 1989, set the legal framework for foreign direct investment by allowing foreign investor to form equity joint ventures with Chinese partners.  Since then, annual Foreign Direct Investment (FDI) has been rising steadily.

Sino-foreign linkages, however, differ from the inter-corporate alliances in the west.  The Chinese need foreign partnership because they do not have the technology to develop new products or the capacity to export them to the world market.  Thus, making them the weaker partner of the technologically and financially powerful            foreign corporations.  In comparison, inter-corporate strategic alliances in the advanced economies arise among firms of equal strength on the basis of complimentarily skills, competencies and technology.  They are pulled together by a competitive strategy for developing better products in a faster and in more efficient ways (Nueno & Oosterveid, 1988).  This brings China to exercise more restraint in policy ambivalence and minimize policy contradictions instead repeating the swings of the previous decades to maintain the Global linkages.

At the end of the 20th century, the globalizing trend of the world economy is beginning to effect on the government management of the national economies. National governments are turning increasingly to the market for economic management and retreating from their insulation against the international market forces. In this period of transition from mercantilist, command and protection-oriented national economies to global market forces, all national economies have ambivalent and sometimes contradictory policies. Thus, the United States holds onto managed trade through quota, retaliation and strategic trade policies. At the same time, it seeks to enhance national competitiveness by creating the advanced factor endowments and infrastructure (Barnet & Cavanagh, 1994), such as the project on information highways. The second largest economy Japan rejects managed trade but maintains voluntary export restraints. The People’s Republic of China is also in a period of transition from the command economy. It is trying to create market mechanisms to attract foreign investment as well as establish linkages with the global economy.

Until the mid-1980s, auto manufacturing in China remained dependent on a comprehensive or fully vertically integrated system of production. This applied to both vehicle assembly and parts and components production, be they under the supervision of the central industrial ministries or local governments. The big and comprehensive plants started by imitating the Ford system of the 1930s, copied from the Soviet Union during the 1950s.6 But the fixed relations between the manufacturers and their matching suppliers which the government had installed to support entry, balance demand and production as well as guarantee 80% of the inputs supplies needed by the enterprises in China’s three 80s supplies system7 were responsible for maintaining and diffusing it. By 1979, numerous small and comprehensive and medium and comprehensive auto makers which the local authorities had established to support the development of the local industries had joined two centrally managed volume producers, (8) contributing to a total of about 130 assemblers that built 185,700 vehicles for the year, mostly trucks and truck chassis. Combined, they had matching relations with more than 2,000 direct suppliers whose number just about doubled at one point in the mid-1980s.

China entry of WTO (the World Trade Organization) is becoming a foregone conclusion, now that it has signed a landmark bilateral trade agreement with the United States and is to start one more round of talks with the European Union and other WTO members. The country will benefit from accession to WTO, but will have to pay a price for it, meaning the projected WTO entry will create both opportunities and challenges for the country. Basing itself on China commitments to market access, this paper attempts to analyze the impact of WTO entry on the country automobile industry

Nowadays, neither market demand nor corporate operation confines themselves to the territorial borders of the nation-states. To survive in a global marketplace, companies must compete globally. Moreover, they rely on strategic alliances (1) with former rivals to succeed. Gone are the days when the Ford Motor Company could act as a lone ranger in pursuit of global growth (Barnet & Cavanagh, 1994). Firms need strategic alliances not only to pull skills and human resources, improve understanding of diverse national tastes and share risks and costs in R&D and production (Lei, 1989; Gugler, 1992), but also to cross policy barriers and take advantage of policy incentives (Barnet & Cavanagh, 1994)–both established and maintained by government regulations.

Whereas the national governments are turning to the market to manage the national economies, the market forces are shifting more and more power to the global corporations. When private investment replaces public funds in financing, it in turn affects the national economic boundaries. First, the sources of the factor endowments that determine corporate and national competitiveness have changed. Instead of physical resources, they now increasingly depend on the existence and strength of the strategic alliances. Second, the ownership of these factor endowments has also changed. The national corporations and their foreign allies claim it jointly. Still, national governments continue an effort to maintain the boundaries, both to improve national competitiveness and to meet the demands of the domestic politics, which make it imperative to keep up with certain level of employment and demands of the national security.

From 1949 to 1980, China managed its command economy by periodically shifting the locus of policy making between the center and the provincial governments on the one hand and between the former and the production units on the other (Schumann, 1968). When flexibility in policy implementation was needed for the policy of the center to suit the local conditions, the central planners in Beijing would decentralize decision-making power to the provinces and/or the factories (Schumann, 1960). But when decentralization led to cellularized local production and trade contrary to the objective of developing inter-regional specialization of production, economy of scale and comparative advantages of resources (Donnithorne, 1964, 1972), they would take back the policy making autonomy (Reynolds, 1978), resulting in cyclical shifts in reforms (Winckler, 1973; Nathan, 1976).

In automobile manufacturing, worldwide competition has also driven the producers in the Triad towards strategic alliances (Husbands & Schuller, 1993). Wherever they take shape, these alliances bring along the pressure on realigning the manufacturer-supplier relationship. While they phase out standardized products and processes in the Triad, global producers are also extending their life cycles to those economies at lower tiers of technological development that offer strategic potentials for automobile consumption and production.

China began taking over these standard products and processes to upgrade the skills and technology in auto manufacturing from the late 1970s onwards. Since the initial projects on technology imports and joint assembly ventures were limited in scale and incidental in nature for China’s auto industry, the local governments that had traditional control over the local supplies did not want to discontinue the administrative style of managing the automotive business. Neither did they give much consideration to the effect of such policy on the foreign partners of the joint ventures. Short of upgrading the subordinate enterprises that were engaged in parts and components production, including both numerous assemblers themselves and the suppliers which had fixed matching relations with them, administrative control proved effective for keeping them in business. This protectionist approach to management, however, made it difficult for the joint venture assemblers to build linkages with China’s domestic suppliers. It prolonged their dependence on foreign supplied knockdown kits and helped to put a constraint on scale expansion in these assemblers.

But its transition to large-scale import-substitution car production since the late 1980s has made it impossible for China to ignore the demands of the foreign investors. To raise the domestic content of the vehicle assembly, a second-stage development of the import substitution production, it has had to deal with the problem of product quality, a key purchasing condition of the joint venture auto builders. The matching suppliers are forced to modernize as speedily as possible to prevent more businesses from losing to the foreign suppliers and new entrants like the defense enterprises. Similarly, the local governments are racing to improve the local business climate so as to lure the badly needed capital and domestic sourcing business into the areas under their own geographical control.

 

1.2         Benefiting Backward Linkages

 Backward Linkages exist when the growth of an industry leads to the growth of the industries that supply it; for example, growth of the textile industry may encourage the growth of the cotton industry, which will lead to higher incomes for cotton farmers and will create a greater demand for goods and services in the countryside

Prior to China’s entry into the WTO the Chinese government restricted the foreign ownership of auto parts companies and foreign investors were limited to no more than 50% ownership. They were also required to invest a fixed percentage of sales into R&D and both automakers and auto parts companies had to comply with local content requirements. The result of these regulations was a local auto parts industry that was not competitive in the global market. When it became clear that China was going to enter the WTO and that rules regarding auto industry investment would be liberalized the foreign investment activity in the auto parts area took off.
In 1996, just six years ago, the US imported from China auto parts valued at 711 million dollars. This made up 1.46 percent of total U.S. auto parts imports that year. In 2001 we imported 1.758 billion dollars from China. This accounted for 2.84 percent of our auto parts imports. In that five-year span China moved from our eighth largest source of auto parts imports to our fifth largest. While these shifts in trade are amazing in their own right, when one looks at certain product categories an even more dramatic picture emerges. In 1998 we imported a little less than 8 million dollars worth of aluminum wheels from China. This was 2.4 percent of our total aluminum wheel imports. In 2001 that number increased to 75 million dollars or 13 percent of our aluminum wheel imports and moved China from our tenth largest source of aluminum wheels to our third largest. In fact for the first four months of 2002 China has passed both Canada and Mexico to become our largest supplier of aluminum wheels supplying over 18 percent of our imports.

 

1.3       China’s Preferential Policies for Foreign Investment

The Chinese government has and will continue to adopt a series of policies and measures that encourage foreign investment.  The Chinese government is dedicated to the cultivation of a stable and comfortable environment in order to attract more foreign direct investments.

China has monitored the investment in auto industry since the reforms began in the early 1980s. When the reforms produce results different from their original intention, the central government tries to correct it by adjusting the policy-making autonomy. Several times in the past decade it tried to freeze or curb the expansionary investment of the local governments and enterprises so as to stop the resources from being diverted from the centrally supported key projects. More latest examples of recentralization include Beijing’s decisions to unify the circulated currencies and tighten up the control of the banking so as, among others, to more effectively manage the foreign exchange, stop rampant speculation on the real estate and restore payments to the peasants and teachers.

The Chinese central government still depends on achieving flexibility of policy making by shifting the center-periphery relations. However, in many cases these adjustments have also to take into account the country’s emerging linkages with the global economy. They cannot be totally autarkic, as long as China’s national economy is increasingly being linked with the global economy. The central government must consider the consequences in balancing its policy objective with flexibility in implementation in the periphery nowadays. It has had to minimize the destabilizing effect on the interests of the foreign investors when it amends the joint venture laws and prevent such amendment from driving them away. It has also had to introduce some changes in the domestic economic and legal systems to establish or maintain the global linkages. For instance, China may have to grant the burgeoning securities markets independence from the oversight of the People’s Bank of China and give the foreign creditors more legal rights versus the Chinese factory directors to draw capital from the world. (1)

This means that the Chinese national economic boundaries have become porous with the global linkages. In automobile manufacturing, more than in any other industries, China has witnessed the porousness of the economic boundaries thanks to the extensive linkages it has built with the global economy. In the same industry, China has also had frequent opportunities to display its policy ambivalence and contradictions towards the global market forces. The Chinese have had to rely on the global linkages to develop their auto industry, despite their preference for having a national industry. They want to develop it into a “pillar industry”, (1) one that represents the maturing of the industrial revolution in China, even though it contributes only modestly to its employment and national income.

The Chinese enterprises had tried to come together in groups after assuming “self-management” and a renewed profit retention scheme in the early 1980s, with the objective of expanding market, adding new products, concentrating the industry, rationalizing production as well as securing the certainty and improving the quality of the inputs supplies. Some auto assemblers, components suppliers and a number of defense factories interested in entering automotive business formed combined management companies (CMCs)(10)–a sort of divisionalized conglomerates. A core enterprise, usually the largest and technologically strongest assembler in a group, coordinated production as well as managed procurement and marketing across the municipal and provincial boundaries, where the group members were located, thereby achieving a degree of specialization and division of labor within a CMC.

But the conglomerate strategy ran into difficulties, because the local authorities that were interested in promoting local industrial development would continue to support the operation of the incompetent enterprises under their geographical jurisdiction, often allowing them to continue to dump shoddy inputs on the assemblers, disregarding its concerns for quality. In the event, only those technologically more sophisticated builders that had powerful political connections in the center, such as the Second Auto Works (SAW), were able to resist this administrative pressure to a degree.

In other words, decentralization was generating fragmentation again as in previous decades. But instead of taking back the control as previously, the central authorities extended it. This was because China had had to turn to foreign technology to add new products and modernize facilities, after having devoted the past decades to simple reproduction for a captive market while neglecting product quality, design and R&D. (14) To solicit foreign linkages in developing the auto industry, maintaining an impression of autonomy in the periphery became necessary. This shift in the development strategy of China’s auto industry found support in the general policy of the central authorities. As early as 1979, the central government had in the legislation for special economic zones (SEZs) removed the principle of “self-reliance” from national economic development. Now, it was switching from relying on SEZs towards using China’s large and medium-sized state enterprises, its main industrial base, to transfer the type of technology the country needed for upgrading its technological capabilities.

To attract investment and other types of technical linkages from the global corporations into these enterprises, China had to improve the terms of foreign investment. As it began to amend its legislation, China had also to incorporate the lessons of Sino-foreign joint ventures learned in SEZs. In the 1983 provision to the joint venture laws, for example, it lengthened the period of partnerships to give foreign investors more time to recover their initial investment. It made conditional concessions on inputs sourcing requirements to enable the foreign partners to supervise product quality in line with the image of their brand names. Similarly, the 1983 provision opened up China’s market conditionally to allow them to broaden product sales. In retrospect, it also laid out a foundation for resolving the problem of the shortages in foreign exchange that might plague a joint venture if it depended on the imported knockdown parts and materials for production.

To assure foreign investors of the autonomy of the Chinese enterprises, the People’s Congress further enacted the General Principles of the Civil Law in 1986 to authorize the managers of a limited number of the enterprises with the power to sign contracts directly with foreign technology suppliers, subject to prior approval of the Ministry of Foreign Economic Relations and Trade. This coupled with the promulgation of the Provision of the State Council for the Encouragement of Foreign Investment in the same year that reaffirmed joint ventures autonomy in management, including that for marketing and procurement.

In June of 2001 China published its 10th Five-Year plan for the Development of the Automotive Industry. This Five-Year plan recognized the problems associated with the auto parts industry and outlined proposed actions to be taken to improve the competitiveness of the auto parts industry in China. For the past ten years investment in the auto parts industry has lagged that in rest of the auto industry. Less than 30% of investment in the auto sector went to the auto parts industry. The investment which did take place did so to comply with the local content provisions. With WTO these provisions are eliminated and companies will have to compete based on price and quality. The result of the local content requirements is and auto parts industry with too many auto parts companies with too little size and second-class technology. Recognizing this the goal of the latest five-year plan is to support those portions of the auto parts industry where China has.

The result of all of these policies and programs is expected to be a lean and mean auto parts industry. The number of suppliers is expected to be reduced by 70% including the foreign joint ventures. These companies are expected to have world-class technology and be competitive in the global market not just in China. Whereas today a Chinese auto parts company is likely to supply only one automaker or a few small automakers with a total annual production capacity of less than 100,000 units, the target is to have companies with more than one customer and annual parts production capacity of at least one-half million units. I believe it is the Chinese government’s objective to have a cadre of companies similar to a Mando Machinery, Johnson Controls, or Denso. Given the advantages and disadvantages of a Chinese home base the early Chinese mega-suppliers are likely to come from the following sectors: wire harness systems, casting suppliers, and exhaust system suppliers. There are advantages to manufacturing these products in China such as low labor costs, access to raw materials and less stringent environmental regulations, and growing market potential. Like Mexico in North America China also may become a regional or global source for engines due to the factors listed above.
In some cases the future is already here or at least evident.

 

1.3       Technology Absorption and Adoption

In the last several decades international technology diffusion has played an important role in narrowing technology differences and the income gap between advanced and less advanced countries. Most empirical studies on this issue rely first firm in China to produce the product. In contrast, only 20% of collective-owned enterprises reported being the first. Regression analysis suggests that the choice of being a `market leader’ is strongly influenced by firm characteristics, e.g., ownership, firm size, firm age, and capital intensity. The choice of being a leader or a follower is also related to other aspects of technology choice, e.g., the origin of technology (from advanced countries or newly industrialized countries), project expenditure, and financial sources. On the other hand, technology choice impacts firm performance. The endogenously of technology choice poses certain difficulties when we evaluate the effect of technology choice on firm performance. It is always possible that some unobserved firm attributes, e.g., the willingness of managers to take risks, might be correlated with technology choice and affect firm performance.

 

 SYNTHESIS

The development of the Chinese automobile industry and its entire economy is propelled by the shift from the command economy to an open economy that allows free flowing foreign investment. China’s automobile industry has yet to develop the necessary technological and personnel expertise that an assembly line needs. This is not to mention the capital needed in developing the industry and exporting it to the world market. Thus, the reliance of its automobile industry on foreign technology and capital is not altogether surprising. This implies that foreign investors determine the course that Chinese automobile industry has to take. However, the process of globalization in the automobile industry and accompanying global linkages has also begun to restructure the manufacturer-supplier relations in the Chinese auto industry.

In recent years, the Chinese government has instituted policies that will significantly help the Chinese automobile industry. Programs such as the Five-Year plan for the Development of the Automotive Industry will drive local investors in developing a national industry that is both competitive and reasonably priced. Further, the technological and skill absorption derived from the experiences in foreign companies will bring the boost that the automobile industry needs.