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905M07 GM IN CHINA1 Danielle Cadieux prepared this case under the supervision of Professor David Conklin solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail [email protected]. Copyright © 2004, Ivey Management Services Version: (A) 2009-09-30

We have an enviable position in the world’s fastest-growing automotive market, China, where investments in the mid- and late 1990s have paid dividends far larger and sooner than anyone predicted. Our unit sales in that market increased 46 per cent last year, and we increased our market share.2

A leap over the cliff: are the big profits to be made in China blinding foreign carmakers to the risks ahead? A flood of investment is causing concern that the industry will soon be vulnerable to overcapacity. There are also longer term doubts about the rules by which Beijing expects manufacturers to play.3

CHALLENGES IN CHINA Founded in 1908, GM was the world’s largest vehicle manufacturer, with 15 per cent of the global vehicle market and manufacturing operations in 32 countries. Beginning in 1992, GM created many joint ventures with Chinese government-owned enterprises, and by 2004, GM had attained outstanding profit levels. However, by the fall of 2004, a series of issues threatened GM in China, and several of these issues raised doubts about GM’s strategy. China’s entry into the WTO had led many to hope that the government’s interventionist policies would come to an end. However, in 2004, the government of China promulgated a series of rules in regard to the motor vehicle sector, making it clear that intervention would be ongoing. Of particular concern was the continuing requirement that foreign ownership of assembly factories would be limited to 50 per cent, requiring a government-owned enterprise as an equal partner. Meanwhile, intellectual property was not being protected in the way that automakers had come to expect in other countries, causing concerns about Chinese competitors copying the models and designs of foreign corporations. 1This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of General Motors or any of its employees. 2General Motors Corporation Annual Report 2005. 3J. Mackintosh and R. McGregor, “A Leap Over the Cliff,” Financial Times, August 25, 2003, p.13.

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Page 2 9B05M007 While sales growth had been truly exceptional, there were many reasons to doubt that the rapid pace could continue. Furthermore, huge investments by competing firms would result in substantial increases in production volumes, threatening a reduction in prices and consequently in gross margins and profits. As part of its macroeconomic policies, the government of China arbitrarily imposed restrictions on automobile financing as a way of restraining inflation, but this sector-specific intervention introduced a wild card into demand projections. Having kept the foreign exchange rate at an overvalued level for many years, it now appeared that the government might allow the exchange rate to rise substantially, and this could severely reduce the international competitiveness of China’s vehicle manufacturers. The degree to which Chinese production facilities could be used as a low-cost export base remained an important and related question. At the same time, the government faced a series of questions in regard to the policies it should put in place for the motor vehicle sector. Through its regulations, the government had consistently played a major role in directing the growth of the sector. In particular, its requirement for 50 per cent Chinese ownership of each manufacturing investment constrained investment and managerial decisions by foreign firms. However, it was not clear what rules could best provide for China’s future economic success. Many developing countries had imposed foreign ownership restrictions, but had later reduced or eliminated these restrictions in order to stimulate investment and economic growth. Perhaps China would also follow this path. By 2004, inflationary pressures were building, and the government imposed credit limitations to restrain purchases of vehicles, raising the question of the appropriate role for sector-specific intervention as a component of China’s macroeconomic policies. Meanwhile, air pollution was becoming extremely severe, and the road system was becoming increasingly inadequate. These developments, as well, meant that government interventions to limit pollution and to expand the road system would be important determinants of future motor vehicle sales. GOING TO CHINA By 2004, GM had about 10,000 employees in China, and it operated six joint ventures and two wholly owned foreign enterprises. GM had participated with its joint venture partners in investments of over $2 billion in China. With a combined manufacturing capacity of 530,000 vehicles, GM and its joint ventures offered the widest portfolio of products among foreign manufacturers in China. GM’s major joint venture partner, SAIC, had been founded in 1956, and, by 1997, had grown to become China’s largest manufacturing plant. As presented in GM company reports, these joint ventures consisted of the following: Shanghai General Motors Co. Ltd. (Shanghai GM) Shanghai GM was a Shanghai-based 50-50 joint venture with Shanghai Automotive Industry Corporation Group (SAIC). The largest automotive joint venture in China, Shanghai GM was formed in June 1997 with an initial planned investment of $1.3 billion and an annual production capacity of 200,000 vehicles while operating on three shifts. Shanghai GM assembled and distributed a family of Buick midsize sedans, the Buick GL8 executive wagon and the small-size Buick Sail. Shanghai GM began producing engines in 1998. Its powertrain facility had an annual production capacity of 180,000 V-6 engines, 75,000 L-4 engines and 100,000 automatic transmissions.4 Shanghai GM was supported by a network of sales, aftersales and parts centres. 4www.autointell-news.com/News-2002/November-2002/November-2002-1/November-06-02-p10.htm, accessed October 20, 2004.

Page 3 9B05M007 SAIC-GM-Wuling Automobile Co. Ltd. (SAIC-GM-Wuling) SAIC-GM-Wuling was a $99.6 million joint venture launched in November 2002 and capable of producing up to 180,000 vehicles per year. GM held a 34 per cent stake, while SAIC held 50.1 per cent and Wuling Automotive 15.9 per cent. This joint venture was situated in Liuzhou, in western China, and it manufactured a range of mini-trucks and minivans. Shanghai GM Dong Yue Motors Co. Ltd. Dong Yue Motors Co. Ltd. was a $108 million joint venture manufacturing facility situated in Yantai, Shandong. Shanghai GM held a 50 per cent stake, with GM China and SAIC each holding 25 per cent stakes. The facility began production of the Buick Sail in April 2003 and had an annual designed production capacity of 100,000 units while operating on two shifts. Shanghai GM Dong Yue Automotive Powertrain Co. Ltd. Dong Yue Automotive Powertrain Co. Ltd. was located in Yantai, Shandong in northeastern China. The joint venture was the former Shandong Daewoo Automotive Engine Co. Ltd., which began production in August 1996. Under an agreement signed in 2004, Shanghai GM would own 50 per cent of the new joint venture, while GM China and SAIC would each own 25 per cent. The facility would have an annual manufacturing capacity of 300,000 engines, providing engines for vehicles manufactured in China by GM and SAIC’s joint ventures. Jinbei General Motors Automotive Co. Ltd. (Jinbei GM) Jinbei GM manufactured the Chevrolet Blazer SUV. In 2004, a new shareholder structure was put in place, with Shanghai GM holding a 50 per cent stake, while GM China and SAIC each held 25 per cent stakes. Located in Shenyang, Liaoning, Jinbei GM’s production capacity was 50,000 vehicles. Pan Asia Technical Automotive Center (PATAC) PATAC was a $50 million, 50-50 joint venture between General Motors and SAIC. It provided automotive engineering services including design, development, testing and validation of components and vehicles. Among its achievements was the reengineering of the Buick Regal, Buick Excelle and other products for Shanghai GM. GM Warehousing and Trading (Shanghai) Co. Ltd. GM Warehousing and Trading was located in Shanghai’s Waigaoqiao Free Trade Zone and represented a $3.2 million investment by GM. The wholly owned parts distribution centre (PDC) officially started operation in August 1999. It was established to ensure the quick delivery of genuine GM and AC Delco parts to customers in mainland China. The PDC featured a fully computerized management and inventory control system and stocked about 25,000 different parts.

Page 4 9B05M007 GM (China) Investment Corporation GM China was a wholly owned venture based in Shanghai. It housed all of GM’s local staff and was the investor in GM’s vehicle joint ventures in China. Sales, marketing and aftersales services were key functions of GM China. Cadillac, Opel and Saab products were imported from GM facilities worldwide and were marketed in China. GM China also supported a network of authorized service centres and parts distributors across China. GM-Shanghai Jiao Tong University Technology Institute GM-Shanghai was a co-operative institution established by GM and Shanghai Jiao Tong University, focusing on joint research and development and on technical training. General Motors Acceptance Corporation (GMAC) GMAC was one of the world’s largest automotive financing companies, serving more than eight million customers in 35 countries. In 2004, the government of China gave it permission to operate in China, and it was actively seeking to develop local partnerships. ACDelco ACDelco, the world’s leading aftermarket brand, operated a growing network of more than 100 ACDelco service centres in mainland China. The facilities, which stocked genuine ACDelco parts, provided repair and maintenance services for all makes and models of vehicles. Allison Transmission Division (ATD) ATD was the world’s largest producer of automatic transmissions for medium- and heavy-duty trucks, buses and specialty vehicles. ATD was working with Chinese original equipment makers and end-users to upgrade the quality of its medium and heavy commercial vehicles. Electro-Motive Division (EMD) EMD was recognized as a world leader in the design and manufacture of locomotive equipment and technology. EMD operated a representative office in Beijing that established links with China’s railway industry.5 Shanghai GM had introduced a series of new products in China: • In April 1999, Shanghai GM began regular production of three models of midsize luxury sedans: the

Buick Xin Shi Ji (New Century), Buick GLX and Buick GL.

5www.gmchina.com/english/news/background/inchina.htm, accessed October 20, 2004.

Page 5 9B05M007 • In May 2000, Shanghai GM launched the driver-oriented Buick GS sedan and the first executive

wagon made in China, the Buick GL8. • In August 2000, a sedan with a smaller engine, the Buick G, was added to the portfolio. • In December 2000, Shanghai GM’s first small car, the Buick Sail, came off the production line. • In October 2001, Shanghai GM began exporting the GL8-based Chevrolet Venture to the Philippines. • In November 2001, Shanghai GM introduced the Buick S-RV recreational vehicle. • In November 2002, Shanghai GM announced that it had secured a contract with GM’s CAMI joint

venture in Canada to export engines beginning in 2003. • On December 26, 2002, the Buick Regal midsize sedan was introduced. • On April 19, 2003, Shanghai GM unveiled the Buick Excelle, its first lower-medium sedan.6 INDUSTRY STRUCTURE: COMPETITION AND PROFITABILITY In 2004, sedans represented 44 per cent of motor vehicle sales in China, with trucks at 30 per cent and buses at 26 per cent. In was in the sedan component that growth promised to be most rapid and where profits appeared to be most substantial. In 2003, Volkswagen had dominated the sedan market with a 36 per cent share. However, by June 2004, GM and its joint venture partners were selling more sedans than Volkswagen, with their joint ventures accounting for 40 per cent of the total sedan market. By 2004, GM was earning exceptionally high profits from its China operations:

China is no longer merely a market of great potential. It’s now the real McCoy, where global companies with the right partners and strategies can and do reap huge profits. The proof is on page 37 of General Motors Corp.’s 2003 report to the federal government called a 10-K under the heading “Investment in Nonconsolidated Affiliates.” Right there, for the first time ever, GM publicly revealed how much profit it is raking in from its vehicle-making ventures in China. The number was a big one: $437 million last year. And that’s only half of the profit from GM’s four joint-venture plants in China, which sold 386,710 vehicles. The other half of the profits went to the Detroit automaker’s Chinese partners. For some perspective, look at the numbers this way: Figure that GM and its Chinese partners had a combined net profit of nearly $875 million, or about $2,267 per vehicle sold in China. In North America, GM’s net profit last year was only $811 million on sales of 5.6 million cars and trucks in the United States, Canada and Mexico, or about $145 per vehicle. That means GM China was nearly 15 times more profitable, per vehicle sold, than GM North America.

6www.gmchina.com/english/operations/shgm.htm, accessed October 20, 2004.

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“GM is making money hand over fist in China, selling cars as fast as they can make them, at very attractive prices,” says Kenneth Lieberthal, a University of Michigan professor and China expert who was senior director for Asian affairs on the National Security Council under President Bill Clinton. “All of the other car markets of the world are either mature or they’re poor.”7

While GM had achieved outstanding results to date, nevertheless a plethora of competitors were fighting for market share. In 2004, China had more than 200 carmakers. Most were relatively small Chinese firms, and these domestic firms, solely owned by the government, had a 40 per cent market share. Exhibit 1 indicates market shares as of June 2004. The government was reluctant to see its motor vehicle manufacturers eliminated by the new joint venture firms. How to support their existence while also attracting foreign technology and managerial skills posed serious challenges at this point in time. As one analyst saw the strategy of domestic firms:

With Japanese and U.S. technology battling it out for the top, the only hope for domestic carmakers without joint venture partners is to capture the bottom end of the market, then begin the slow ascent up the price-and-sophistication ladder. That’s the path chosen by BYD, the former bombmaker. The Flyer retails for about $4,700, making it affordable to the 50 million Chinese earning at least $7,000 a year, whom the government considers middle class. “Look around my office,” says Liu, the BYD general manger. He has one dusty filing cabinet, bare whitewashed walls and a view overlooking the decrepit former bomb factory. “We can get by on the slimmest profits.”8

This industry structure created great uncertainty about future prices. The domestic firms did not have shareholders demanding certain profit levels, and so they might strive to maintain their market share by cutting prices. Furthermore, an ongoing temptation for them was simply to copy the designs and technologies that were being introduced by the new joint venture firms. Meanwhile, foreign competitors were jostling to increase their investments in this fast-growing market, a process that would further intensify price competition. Already, over the 2001-2004 period, prices had fallen 25 per cent. Analysts expected prices to continue to fall at a rate around 10 per cent a year.9 UNCERTAINTIES OF DEMAND AND SUPPLY PROJECTIONS Some analysts extrapolated the exceptionally high growth rates of the 1999-2003 period to arrive at projections of enormous sales volumes. China’s auto sales had climbed from some two million units in 2000, to more than three million units in 2002, to 4.4 million vehicles in 2003. China’s rapid economic growth supported the view that an increasing number of Chinese would be able to purchase cars in the future. Exhibit 2 presents data in regard to China’s economic growth, and Exhibit 3 indicates the very unequal income distribution as a result of which the top 20 per cent of China’s population would soon be able to afford automobiles. Based on this optimism, some analysts predicted:

7T. Walsh, “GM’s China bonanza,” Detroit Free Press, accessed March 30, 2004. http://www.freep.com/money/business/walsh30_20040330. 8M. Forney, “Moving too Fast? Time, V. 163, I. 8, February 23, 2004, A6. 9“Here be Dragons,” The Economist, September 4, 2004, p.10.

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China is on track to overtake Japan “in a couple of years” to become the world’s second biggest vehicle market, according to John Devine, General Motors’ chief financial officer, in the U.S. vehicle maker’s latest bullish assessment of the mainland. Mr. Devine said GM expected the market to maintain double-digit growth “for some time” on the back of continuing economic growth, cheaper cars and the approval of vehicle financing for three foreign manufacturers. GM China sold 386,710 vehicles in China last year (2003) through its various joint ventures, up 46 per cent on 2002. Saloon car sales increased 82 per cent year-on-year.10

For the motor vehicle sector, the year 2004 witnessed an abrupt end to the 50 per cent annual sales growth of the previous years. Some of the best-selling models experienced particularly sharps decreases, as customers shifted to less expensive automobiles. For some models, September 2004’s sales dropped more than 50 per cent from the September 2003 level. Analysts pointed to a series of new forces: a loss of consumer confidence, expectations of further vehicle price decreases, the threat of oil shortages and higher gasoline prices, government rationing of power supplies, and the government’s abrupt imposition of credit restrictions for automobile financing. Long-term constraints included a very poor highway system — in fact, one analyst suggested that “China has no national highway system.”11 Driving was basically restricted to the roads within each city. Air pollution had become a major concern, and this could also limit China’s motor vehicle growth. “According to the World Bank, China has 16 of the world’s 20 most polluted cities,”12 resulting in 300,000 premature deaths annually due to respiratory disease. As a result of these new developments and long-term constraints, analysts claimed that foreign investments that had once appeared to be enormously successful might now be open to question.13 In the third quarter of 2004, GM saw its profits in China drop 44 per cent to US$80 million.14

Over-capacity will be a major factor within two years, with the passenger car market — already the single most important sector within the Chinese vehicle market — likely to be at the forefront. Paul Brough (managing partner of KPMG’s financial advisory services practice in China) continued: “We are already seeing the first outward signs of the pending over-capacity. Average car prices in China have already fallen by seven per cent between January and June this year (2004). A lot of this can be attributed to manufacturers looking to grab early market share through aggressively low pricing. In addition, rising inventory levels are also forcing price reductions on older models as businesses look to clear stock levels.” “Further over-capacity will see increased price pressures on sedans as well as lower prices and margins. Taking the reasoning to its ultimate extreme also raises the fear of some new production facilities becoming real white elephants as capacity is inevitably scaled back at some point.”15

10Richard McGregor, “GM to focus on growing China market,” Financial Times, February 12, 2004, p.20. 11Mark Graham, “Paddy Fields to Full Production,” Industry Week, November 6, 2000. 12“Special Report on China’s Environment: A Great Wall of Waste,” The Economist, August 21, 2004, p.56. 13Peter Wonnacott, “Slower Growth Fuels Anxiety,” The Wall Street Journal, October 21, 2004, B13. 14Richard McGregor, “Carmakers Changing Plans as Chinese Sales Fall Off,” Financial Times, October 16, 2004, p.2. 15“Significant Over-capacity to Hit Chinese Car Market within Two Years,” www.kpmg.com/search/index.asp?cid=753, accessed August 27, 2004.

Page 8 9B05M007 As noted above, the intensification of competition was resulting in price cuts that would inevitably reduce profit margins. Furthermore, it was not clear whether certain supply constraints might limit the expansion plans of China’s automakers. In August 2004, a Financial Times article pointed to a decrease in car production of 20 per cent compared with the previous month, and noted that, “This is forcing a rethink among multinational and local carmakers about their multibillion-dollar expansion plans in China.”16 FIRST MOVER ADVANTAGE IN CREATING A VALUE CHAIN The industry structure of parts suppliers had a similar dual nature. On the one hand, the joint venture enterprises initiated by foreign parts suppliers brought modern technologies and managerial practices. On the other hand, domestic firms pursued traditional practices that resulted in poor quality components and that lacked innovation and ongoing product development. A persistent temptation for domestic firms was to label their parts falsely, claiming them to be the genuine products of firms with brand-name recognition. A foreign assembler had to create an efficient value chain capable of creating vehicles that would be consistently high quality. Just-in-time delivery practices faced real challenges in China.

The joint venture operations many of the Tier 1 suppliers have set up very little in terms of technological sophistication and part quality between what they do in China and the rest of the world, says Guy Bouchet, a vice-president with A.T. Kearney. He recently returned to Chicago after spending five years in China. The rest of the local supply base is a different story. It’s fragmented, and there’s a wide spectrum of capabilities, qualifications and quality, he says. Some of these suppliers understand the multinationals’ requirements and are ready to play the game. Others aren’t so willing or able. “Late-comers run the risk of not being able to lock in business relationships, in whatever form, with the highest-capability guys,” says Bouchet. “You have to tap into a second tier who are not as good, which means that your investment in terms of training, in terms of revamping the assets, are higher, which has an impact on your return on investment and your short-term competitiveness.”17

NEW OPPORTUNITIES WITH SALES FINANCING In 2004, China’s four state-owned banks held more than 80 per cent of China’s outstanding automobile loans, while the automobile manufacturers had been prohibited from extending loans as part of their sales programs. In August 2004, General Motors became the first overseas automaker in China to be allowed to issue car loans to its purchasers. GM had created a new joint venture for its financing operations, with 60 per cent owned by General Motors Acceptance Corporation (GMAC) and 40 per cent owned by SAIC. Analysts expected that this expansion would greatly increase GM sales. Other automakers had also applied for permission to offer auto loans, but GM had a head start. Overseas banks such as Citigroup Inc. and HSBC faced a delay of several years before they would be allowed to offer loans denominated in yuan to Chinese purchasers. GM now enjoyed a brief window of limited competition. However, GM’s finance operations faced certain restrictions. Initially, GM could lend as much as 90 per cent of the car’s price tag, but this percentage could be reduced by government regulation as a mechanism

16Richard McGregor, “Chinese Car Output falls by 20%,” Financial Times August 25, 2004, p.13. 17David Drickhamer, “Balancing Act,” Industry Week, February 2004 V. 253, I. 2, 49.

Page 9 9B05M007 for restraining demand in time of inflation. Furthermore, China’s central bank determined the interest rates to be charged on local currency loans; GM would not be allowed to set its own rates. POST-WTO CHALLENGES: THE PERSISTENCE OF GOVERNMENT REGULATIONS, TRADE AND INVESTMENT RESTRICTIONS, AND VIOLATION OF INTELLECTUAL PROPERTY PROTECTION WTO Provisions Prior to joining the World Trade Organization (WTO), China had imposed exceptionally high tariffs on motor vehicles and components, and has also imposed import quotas for certain products. China was granted a transition period in tariff reductions, with a decrease from levels of 80 per cent to 100 per cent down to 25 per cent by 2006. Import quotas were to be phased out by 2005. In the past, the government had also imposed local content requirements in order to support domestic suppliers of components, but these also were to be eliminated. In addition, the government had intervened to dictate the types of vehicles that foreign companies manufactured, with production licences as a requirement. With the WTO, foreign companies received greater independence in production decisions, and by 2004, they were free to distribute whatever products they wished. While China maintained its 50 per cent domestic ownership requirement for assembly plants, the government did eliminate its joint venture requirements for the production of engines. Some analysts predicted that these WTO reforms would give foreign companies valuable new opportunities. In particular, foreign companies would be able to import certain segments of their product mix, while focusing their China production on a limited product range, thereby capturing greater economies of scale. This would mean that foreign companies could rationalize their product mix globally, and China’s place in global production would depend on its inherent competitiveness. Meanwhile, the domestic firms would face heightened import competition, as would component manufacturers.

These market-opening commitments are expected to bring considerable challenges — and opportunities — for both Chinese and foreign automakers. For Chinese companies, the challenges will likely outweigh the opportunities. Reduced tariff and non-tariff barriers will allow high-quality, inexpensive foreign vehicles to flood the domestic market. China’s small and inefficient auto companies will probably be unable to compete with well-established multinational competitors.18

Persistent Government Intervention In June 2004, the government of China proclaimed its new version of rules concerning foreign investment in China’s vehicle sector. Exhibit 4 presents KPMG’s summary of these rules and their implications. Some rules were unchanged from the past, but overall the June 2004 proclamation represented an ongoing intervention that carried uncertainty with it. For example, in discussions about formulating these rules, analysts had warned of the possibility that the government might impose new rules to support technology development in domestic companies. In particular, a policy option being debated was that 50 per cent of all sales in China by 2010 would have to come from domestic companies that would own 100 per cent of a vehicle’s technology. An additional proposal was that any foreign company that owned 10 per cent or

18Allan Zhang, “China’s WTO accession: Implications for the auto sector,” www.pwc.com/servlet/printFormat?url=http://www.pwc.com/extweb/newcloth.nsf/docid/F117826, accessed May 14, 2004.

Page 10 9B05M007 more of a Chinese company would be compelled by law to share its expertise in research and development, production and sales. The 2004 rules did not include these provisions, but the possibility remained that similar provisions might be imposed in the future to enhance Chinese ownership of technology.19 CHALLENGES OF THE JOINT VENTURE REQUIREMENT China’s requirement that foreign investors enter joint ventures with domestic firms was a position held by many developing country governments in the mid-to-late 20th century. It was generally accepted throughout the world that foreign direct investment (FDI) led to some degree of loss of control by host country governments over their economies. This loss of control was seen as a cost to the host country and to its government. Transnational corporations (TNCs), with international production and distribution networks, had the flexibility to respond more quickly to changing conditions in all the countries in which they operated than did domestically owned firms. If, for example, a host country’s real exchange rate rose, a TNC could reallocate production to a cheaper source of supply in another country. A domestically owned firm might not have this option, or, if it did, it might exercise it less quickly. A similar situation existed with many of the major policy variables under government’s command. Governments might lose control over their ability to raise taxation rates, wage rates and labor conditions, interest rates and so on for the fear of the reaction of TNCs in their investment and production decisions. Many believed that TNCs had very different goals for their operations in host countries than did the host country governments. TNCs could also be subject to pressures from a number of sources, and these sources might be outside the influence of host country governments. Consequently, a degree of tension was introduced when foreign investors were permitted to enter the private enterprise system. Not only were TNCs seen as trying to control the operations of their firms in the best interests of their stockholders, but these stockholders were located outside the host country. Put another way, foreign investment implied that some form of direct control was exercised from outside the country. As well, those for whose benefit the control was being exercised also resided outside the host country. Moreover, TNCs were seen as being responsive to the policies and goals of the government in their home country (and other countries in which they operated) and these goals and policies might not be in the best interests of the host country. Based on all these rationales, host country governments wished to be able to exercise a degree of control over foreign investors relative to domestic investors in order to align their operations more closely with the goals of the country. General restrictions on foreign investors were an attempt to lodge some degree of control with domestic entities, either host country nationals or, in some cases, the government itself. However, being the foreign partner in a joint venture raised many difficult challenges.

Under the best of circumstances, joint ventures can be difficult to manage. They’ve gone out of fashion among U.S. auto companies because the interests of the individual parties frequently diverged before the ventures had run their course. What’s worse is that SAIC owns 50% of each joint venture by government regulation and gets half the votes when decisions are made. That’s normally a recipe for frustration and deadlock. Asked how disputes get resolved when neither party has a tie-breaking vote, SAIC president Hu says: “When we have different ideas, we close doors and argue against each other. It is okay to lose your temper as long as the door is closed.” He adds that he has learned a few things about conflict resolution between different nationalities. “Americans

19Leslie P. Norton, “A Bumpy Road for Foreign Auto Makers in China,” Barron’s, June 23, 2003, V. 83, I. 23, MW12.

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have more flexibility than the Germans, who are very serious once they make up their mind,” he says.20

Of central concern was the risk that the domestic partner might create an alternative production facility and compete against the joint venture. Or the government of China might arbitrarily dissolve the joint venture and encourage SAIC to purchase GM’s interest in the joint venture. Nationalization of GM’s interest seemed an extreme possibility but one that could not be completely ruled out. If any of these developments were to occur, GM might now be creating its own worst enemy — and not just in China, but perhaps globally. Nothing would prevent SAIC from exporting to GM’s markets throughout the world.

Some China experts believe the joint ventures will be unwound once the Chinese are capable of competing on their own. “Foreign automakers should be afraid of domestic competition-very afraid,” wrote economist Kroeber. “In sector after sector, foreign manufacturers have piled into China only to see their technology copied and their prices undercut with alarming speed by domestic competitors operating with government support. Chinese firms have picked up technology much faster and kicked foreign competitors out of the market far faster than anyone predicted.”21

And by 2004, SAIC had already shifted into initial stages of competition against GM:

The boldest plans belong to SAIC. In the next three years, SAIC aims to make 50,000 vehicles bearing its own brand; in 2003, the company produced fewer than 3,000 of its own vehicles. By 2010, SAIC wants to be among the world’s top 10 auto makers, according to Xiao Guopu, a vice-president of SAIC.22

In 1978, China had begun its gradual transition from central planning and state-owned enterprises to private ownership in a market economy. It was possible that the joint venture requirement with a government-owned partner might be eliminated in the future. If so, GM would face the strategic issue of whether to attempt to purchase the domestic partner’s interests in the joint ventures. The government would face the strategic issue of how to privatize and whether it should retain a “golden share” with veto rights over certain managerial decisions. In Germany, for example, the state of lower Saxony held a “golden share” in Volkswagen that gave it power to override the board should it decide to shift jobs out of Germany. Protection of Intellectual Property A major conflict between GM and Chery illustrated the threat that domestic firms could copy designs and technologies of the foreign investors. GM created production facilities for a new small car, the Chevrolet Spark, with a planned price of $7,500 and a production date of December 2003. However, before it could begin its sales campaign, one of the local Chinese automakers, Chery, began selling a $6,000 version with many similar features. GM was faced with an important challenge in protecting its intellectual property.

20Alex Taylor III, “Shanghai auto wants to be the world’s next great car company,” Fortune, October 4, 2004, V. 150, I. 7, 103. 21Ibid. 22Peter Wonnacott, “Global Aims of China’s Car Makers Put Existing Ties at Risk,” Wall Street Journal, August 24, 2004, B1.

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The dispute drags GM into the murky waters of intellectual property-rights protection in China, an arena that has snagged makers of sneakers and other goods that saw Chinese companies mimic their wares. The GM complaint is complicated by the fact that Chery is 20% owned by GM’s main joint venture partner in China, Shanghai Automotive Industrial Corp. GM and SAIC make Buick sedans in Shanghai, as well as cars at two other plants elsewhere in China. Yet, as GM’s dispute shows, these companies could face a vexing battle.

GM was not alone in seeing a clone suddenly appear from a domestic manufacturer. Toyota also experienced this challenge:

When Geely, China’s largest private carmaker, launched its Meiri saloon, it made certain to advertise one of the vehicle’s big selling points — its Toyota engine, installed under licence from the Japanese company. Toyota perhaps could have lived with that, but not with the Geely logo plastered on the Meiri’s front grill, which, it considered, looked suspiciously like the stylized T-shape that brands the Japanese company’s vehicles globally. Similar — but not so much that potential purchasers would be misled — ruled Beijing’s Second Intermediate Court this week, throwing out legal action mounted by Toyota for alleged trademark infringement.23

ONGOING RISKS IN CHINA A KPMG Survey in 2004 revealed serious concerns held by foreign investors in China. These ongoing risks threatened GM as well as foreign investors in other sectors: • Forty per cent of those surveyed agree that government regulations posed a significant challenge to

their expansion plans. • Eighty per cent of companies surveyed said that Intellectual Property Rights infringement posed a

significant threat to their businesses in China. • Nearly 25 per cent of those surveyed agree that they overestimated the potential of the Chinese market,

and a further 16 per cent even admitted they wrongly believed they would get rich quick.24 KPMG listed the most prominent mistakes made when investing in China. By working with a joint venture partner, GM had been able to avoid many of these mistakes, and this reality placed a strong positive value on GM’s relationship with SAIC. 1. Failure to appreciate the differences in the Chinese market. Companies that focus solely on the largest,

high-profile coastal cities may miss out. 2. Failure to appreciate the ferocity of domestic competition. Before 1949, the Chinese were known for

entrepreneurship. Since 1978, these trading talents have been reviving, and local companies will go head-to-head with foreign concerns.

3. Investment information can be difficult to get and may not be reliable. 23Richard McGregor, “Chinese Law Courts Make their Marque,” Financial Times, November 28, 2003, 20. 24www.kpmg.ca/en/news/pr20040608.html, accessed July 2, 2004.

Page 13 9B05M007 4. Failure to appreciate and understand cultural differences. In China many common Western cultural and

economic paradigms do not apply . . . Contracts are certainly not worthless in China, but their significance is not as great as they are in the West.25

MACROECONOMIC POLICIES As Exhibit 2 indicates, China had experienced five years of very rapid growth, ranging from seven per cent to over nine per cent annually, without experiencing any significant inflation. In fact, in the years 1999 and 2002, China’s general price level appears to have fallen. However, with the year 2004, analysts throughout the world became increasingly concerned about the possibility of rapid inflation in China, and the government of China shared this concern. Essentially, there was a substantial increase in aggregate demand due to higher consumer incomes, increased levels of exports and substantial foreign investment. At the same time, there appeared to be new constraints on global capacity to produce natural resources necessary for the burgeoning Chinese manufacturing sector. World prices for natural resources, and particularly oil, were skyrocketing, and this threatened to drive up cost levels and, therefore, prices in China.

Inflation in China has become a growing concern to bankers, corporate executives and monetary officials around the world.26 Rapid growth — especially with regard to infrastructure improvements — has turned China into a major oil and commodity importer. With commodity prices rising, and its currency pegged to the low-flying dollar, China’s import costs have soared. Overall, prices for raw materials and energy in China jumped 8.3 per cent in the first quarter of 2004, while overall input costs for China’s manufacturing increased by 4.8 per cent. Other inflationary pressures facing China are its rapidly growing money supply and a new generation of hyperactive consumers whose spending drove up retail sales by 10.7 per cent in the first quarter of 2004.27

In response to these pressures, the government of China instituted policies to restrain demand in specific sectors that seemed to be overheating. The motor vehicle sector became one of the targets for this restraint, and the government imposed restrictions on loans made to finance the purchase of motor vehicles. In other nations, inflationary pressures were often met with monetary and fiscal policies, but the government of China felt constrained in its ability to use these economy-wide measures. The government lacked experience in both fiscal and monetary policies and had not yet developed the many systems on which these policies relied. To raise taxes as a means of restraining aggregate demand, for example, would be a novel exercise with unclear results. It seemed to be an inappropriate time to reduce government expenditures, when the growth process had been so successful. China required new infrastructure expenditures, particularly for the rapidly growing cities along the coast, but also for huge inland projects like the Three Gorges project that would be necessary to generate hydro-electric power. At the same time, tens of millions of people were drifting into unemployment, both with a shift of population from rural areas to the cities and also with extensive employee lay-offs as enterprises strove to increase

25“Consumer markets in China — the real deal?” KPMG international, 2004, www.kpmg.com.cn/pub.htm?id=669. 26“Inflationary Pressures Rising Fast in China,” Taipei Times, April 10, 2004, 12. 27 J. Kurtzman, “Is China Going the Way of Brazil?” European Business Forum, Summer 2004, I. 18, 95.

Page 14 9B05M007 efficiency — both publicly owned enterprises and the increasing number of privatized firms. The threat existed of both inflation and unemployment, creating a difficult choice in macroeconomic policy direction. Monetary policy offered limited hope because of the fragile state of the banking system and because of the loss-making, state-owned enterprises. To restrain credit and raise interest rates on an economy-wide basis might cause a financial and business collapse. In October 2004, the government did experiment in monetary policy by raising interest rates 27 basis points (a basis point is one one-hundredth of a per cent). The world’s media immediately erupted with concerns. The Financial Times ran a front-page headline that read, “China rate rise sends markets into a spin. Central Bank’s first move in nine years hits commodity prices and stocks around the world.”28

The government’s short-term priority is to slow the current rapid rates of GDP growth without triggering a damaging hard landing for the economy. To this end, tightening measures have been targeted rather than broad-based, aimed at cooling particular types of spending in individual industries — notably investment expenditure in the real-estate, steel, aluminum and cement sectors — rather than the economy as a whole. Specifically, the government has raised reserve requirements for banks, and imposed administrative limits on lending to and investment in the offending sectors. This focus on the ability of banks to supply funds is sensible. China’s capital markets are still immature, so it is largely banks that are financing the current bout of overheating. Of course, the authorities could try to ease demand for funds by raising interest rates, but this would probably not just be ineffective but even counter-productive. The sharp rise in bank credit to particular sectors appears to be based not purely on the low cost of capital but on relationships at local levels between government officials, banks and companies. Arguably, a sharp rise in interest rates would end even some of this lending, but such a change would also discourage investment in sectors that are not currently overheated.29

Another force underlying the inflationary pressures was the decision of the government to peg the renminbi to the U.S. dollar. As Exhibit 2 indicates, China was experiencing a positive current account balance as well as huge capital inflows. In a freely floating foreign exchange market, the demand for the Chinese currency would have driven up the value of the renminbi. However, the government wished to maintain an undervalued currency in order to stimulate its exports and restrain imports. Here again, the basic motivation was a political need to create millions of jobs and to expand the economy. The government was able to keep the renminbi pegged to the U.S. dollar by selling the renminbi on the foreign exchange market in return for U.S. dollars and other currencies that it then accumulated as an increase in its reserves. As Exhibit 2 indicates, China’s foreign exchange reserves increased from US$158 billion in 1999 to US$408 billion in 2003. The government of China used these reserves to buy bonds, to a large degree in the United States, a process that enabled the United States to maintain low interest rates in spite of its large US$400 billion to US$500 billion fiscal deficit. This process also increased China’s money supply and thereby created an additional inflation threat. Other nations that followed a policy of maintaining an undervalued currency could deal with the resultant inflationary threat through a tight money policy that

28Alexandra Harney, “China Rate Rise Sends Markets into a Spin,” Financial Times, October 29, 2004,1. 29“China Country Report,” EIU Report, August 2004, www.eiu.com.

Page 15 9B05M007 would restrain aggregate demand. But, as noted above, there were political and economic reasons for being concerned about the impacts of such monetary restraint. Some analysts felt that China’s macroeconomic policies had painted the country into a precarious position in terms of impending inflation and the difficulties and dangers of fiscal and monetary restraint. An additional element in this situation was the concern of other governments that China’s policy in maintaining an undervalued currency was causing job losses in their countries. This was a widespread concern in the United States, where it seemed that China’s macroeconomic policies were causing the “offshoring” of U.S. jobs at a time of relatively high U.S. unemployment. Some administration officials — particularly the U.S. Treasury Secretary, John Snow — publicly urged the government of China to allow its currency to rise in value. By the fall of 2004, the U.S. dollar had devalued substantially against the euro, and this meant that the Chinese renminbi had devalued by a similar percentage against the euro. Consequently, it was likely that European government leaders would soon add their voices to that of the United States in calling for an upward revaluation of the renminbi. Without such action, it was possible that governments in North America and Western Europe might impose new import restrictions on goods from China in order to protect their nations’ jobs. For GM and other foreign investors in China, the undervaluation of the renminbi had offered protection against competitive imports. In this sense, the undervaluation of the renminbi had acted as the tariff, supporting their initial business enterprises. By the fall of 2004, however, the threat of the revaluation of the renminbi and/or the threat of new protectionist measures on the part of foreign governments had created new concerns about the appropriate China strategy. The danger of a financial crisis and economy- wide depression, though remote, seemed a possibility.

All this though, has raised a burning question. Is China’s boom, like those in 19th century America, merely the precursor of an imminent bust? Or is it the harbinger of a more sustainable economic take-off? The lack of consensus is striking. Despite the optimism that attends China’s foreseeable economic future, there are a couple of scenarios under which Beijing’s best laid plans could be thrown off-course. The first concerns the possibility of shortages of coal, electricity, raw materials, port and rail capacity coalescing into an inflationary trend. If this happened, the central bank would have to raise interest rates and the renminbi would probably appreciate. Eventually, either an ill wind or a surfeit of domestic success will cause China’s stellar phase of growth to abate or crumble — just as it has in every emerging economy in history. When that day comes, the fallout may be spectacular.30

CHINA AS AN EXPORT BASE Analysts were pointing to China’s low labor costs and rapidly improving skill levels as the basis for motor vehicle exports. Many saw China as a new global player in the sector at a time when there was already a world glut of production facilities. China had the potential to disrupt existing global production and marketing patterns. Here as well, GM was quickly approaching a crossroads. Should it stand by while its partner SAIC and others created a vibrant export base, becoming GM competitors throughout the world? 30J. Kynge, “The Chinese boom is bound to end in tears. But it might not end for another 10 years . . .with Bumps Along the Way,” Financial Times, March 24, 2004, 13.

Page 16 9B05M007 Or should GM take the initiative and use its China facilities to export to North America and Europe? How should China fit in GM’s global strategy? It appeared that Honda had already made the strategic decision to use China as an export base:

First, the home market. Next, the world. China is poised to become a significant car exporter as production standards rise and costs fall. With Honda’s new plant, there’s a difference: The cars rolling off its assembly lines by early next year are heading not for the Chinese market, but to Europe — the first big push by a foreign carmaker to produce in China for export. If successful, Honda’s Guangzhou venture will be a significant demonstration of the ability of China-based manufacturing to climb the value chain. Specifically, it would signal China’s debut as a car exporter, based on what Tim Dunne of Automotive Resources Asia, a car industry consultancy, describes as the “marrying of Japanese manufacturing efficiency with cheap labor in China.” Production costs at Honda’s Guangzhou plant are expected to be 20% lower than those in Japan, say factory officials.31

THE WAY AHEAD The government of China had created a motor vehicle strategy that had attained outstanding initial success. Domestic firms lacked design capability, modern technologies and managerial capabilities. Allowing foreign investors to create joint ventures with domestic firms had quickly overcome these challenges. By 2004, the question had arisen as to whether this strategy should be modified. What should be China’s next steps in its motor vehicle strategy? For GM, predicting these next steps would be critical in determining its corporate strategy. In many respects, the business environment it faced was changing dramatically. New competitors from abroad and heightened competition from domestic firms were influencing the industry structure. Demand and supply projections seemed subject to great uncertainties. Its joint ventures with SAIC had been extremely profitable for both partners, but should GM trust this relationship to continue indefinitely? In Thailand, where GM had substantial assembly operations, there were no joint venture requirements. Meanwhile, India had a population nearly as large as China’s, as well as low wages and optimistic growth forecasts. Should GM diversify its China risks by investing heavily in India and other Asian countries?

31 David Murphy, “Driving Ambition,” Far Eastern Economic Review, May 27, 2004, V. 167,I. 21, 28.

Page 17 9B05M007

Exhibit 1

MARKET SHARES BY MANUFACTURER

Shangahi VW 15% Shanghai GM 11% FAW VW 11% GZ Honda 5% Tianjin FAW 5% Changan Suzuki 5% Beijing Hyundai 4% Geely 5% Chery 4% Dongfeng Citroen 4% Others 31%

Source: “China’s Automotive and Components Market 2004,” KPMG, September 2004.

Exhibit 2

CHINA ANNUAL INDICATORS

1999 2000 2001 2002 2003

GDP at market prices (Rmb bn) 8,206.60 8,946.80 9,731.50 10,479.10 11,975.80 GDP (US$ bn) 991.4 1,080.7 1,175.7 1,266.1 1,446.9 Real GDP growth (%) 7.1 8.0 7.5 8.0 9.3 Consumer price inflation (av; %) (1.5) 0.4 0.7 (0.8) 1.2 Population (m) 1,250.50 1,261.80 1,273.10 1,284.30 1,295.20 Exports of goods f.o.b. (US$ bn) 194.7 249.1 266.1 325.7 438.3 Imports of goods f.o.b. (US$ bn) (158.7) (214.7) (232.1) (281.5) (393.6) Current-account balance (US$ bn) 21.1 20.5 17.4 35.4 45.9 Foreign-exchange reserves excl gold (US$ bn) 157.7 168.3 215.6 291.1 408.2 Total external debt (US$ bn) 152.1 145.7 170.1 168.3 189.1 Debt-service ratio, paid (%) 11.7 9.3 7.8 8.1 4.6 Exchange rate (av) Rmb:US$ 8.3 8.3 8.3 8.3 8.3 Inward FDI (US$ bn) 38.8 38.4 44.2 49.3 53.5 a Actual. b Economist Intelligence Unit estimates. Source: EIU Report, China, September 2004.

Page 18 9B05M007

Exhibit 3

CHINA, INCOME DISTRIBUTION

0 5

10 15 20 25 30 35 40 45 50

poorest richest

P er

ce nt

of to

ta li

nc om

Quintile of Population

Page 19 9B05M007

Exhibit 4

KPMG SUMMARY OF 2004 MOTOR VEHICLE RULES Policy Policy Maker Impact Foreign Ownership

Foreign Ownership will remain limited to 50 per cent

Although China obtained an exemption from the WTO on rules that ban limits placed on foreign investment, many auto manufacturers were hoping China would eventually relent: this does not appear to be the case

Number of Joint Ventures

The number of joint ventures a manufacturer is allowed to establish remains at two per vehicle segment (sedan, bus and truck)

This regulation gives domestic manufacturers more opportunity to develop their own technology and production bases by increasing the barrier for foreign manufacturers

Minimum Investment Size

A minimum investment of RMB2 billion (US$241 million) is required

The restriction on investments increases the market entry barrier in China

Manufacturing Licence Transfer

Licence transfer from existing vehicle production companies to non-automotive enterprises is not permitted

The policy makes it more difficult for non-automotive companies to diversify their business into the fast growing automotive market in China

Domestic Sourcing and Production

From 2005 (no specific date mentioned), imported vehicles can no longer be stored in bonded warehouses in China Certain imported parts will be subject to the same level of import tariffs as complete vehicles (currently, tariffs on imported cars are 30 per cent to 38 per cent, while tariffs on parts range from 10 per cent to 23 per cent) Cars with major subassemblies (e.g. chassis, engine) that are imported may be taxed as imported vehicles

Import duty on vehicles will be payable upon entry to China. An increase in local manufacturing and sourcing is expected, foreign automotive manufacturers are likely to continue to step up efforts to identify local sources of parts in order to have price competitive products This is already forcing some automakers to further localize their vehicles

Research & Development (R&D)

R&D expenses will be tax deductible in the future

This policy is expected to continue to encourage foreign companies to establish domestic R&D centres as well as encourage local R&D activities and the development of local intellectual property, for example • GM has already established its own R&D centre in

Shanghai • At present, Nissan and Dongfeng Motors are building a

new R&D centre in Guangzhou, which will be ready at the end of 2005