A huge opportunity has been created by the Chinese government’s long-awaited new regulatory policy on the country’s automotive industry. Beijing could not only promote the development of a world-class sector composed of both state-owned and private companies but also—and more important—ensure that Chinese consumers have access to the high-quality, affordable automotive products that people around the world have long taken for granted. To achieve these objectives, however, the government must fundamentally shift the focus of its current industry policy and rethink some provisions of the new one now circulating in draft form.

At stake is the Chinese market, which now has the world’s highest sales-growth rate for vehicles. Indeed, by 2010 China will become the world’s second-largest automotive market, trailing only the United States. The way the new policy is implemented could have a huge impact on the Chinese and multinational automakers and suppliers operating in the country and on the millions of Chinese consumers who will purchase cars during the next few years.

The government’s current policy, now a decade old, certainly had admirable intentions: to encourage the transfer of technology from multinational to domestic manufacturers and to develop an indigenous state-owned automotive industry supported by—but not competitive with—foreign partners. Yet the policy bears all the hallmarks of a planned economy. Entry into the automotive industry by domestic or foreign companies is highly restricted, for example, and government agencies must approve investment plans. A foreign company’s ownership of any Chinese auto manufacturer is limited to joint ventures in which the foreign partner can have no more than a 50 percent stake—something that hasn’t changed as a result of Chinese membership in the World Trade Organization. One provision of recent policy, at least, is gone: until two years ago, new products required approval from the central government.

Current policy has had a mixed outcome. China does have a big and growing automobile-manufacturing base—but it is dominated by inefficient state-owned incumbents and their foreign partners. Most of the cars that these joint ventures produce are sold under the foreign partner’s brand, and to a large extent Chinese participants continue to rely on multinationals for new technology. In addition, Chinese consumers pay 30 to 40 percent more, on average, for autos produced by state-owned companies than do consumers in Japan, the United States, and Western Europe for comparable models. The higher prices result from local-content requirements that force joint-venture partners to buy materials from domestic suppliers, many of which are inefficient state-owned companies.

Surprisingly, a spirited group of new entrants, including some private companies, has made its mark in the industry, despite these regulatory hurdles. The Brilliance China Automotive, Chery Automotive, and Geely Automotive brands, for example, have sold more than five times the combined number of cars sold under the brands owned by the three government-supported automotive groups. The new entrants’ auto prices are already comparable to those in Japan and the West. After entering the industry through the back door by taking over bankrupt state-owned enterprises (a tactic the government permitted in order to save jobs), the new competitors reduced their need for capital investment by optimizing the mix of automated and manual processes. Unlike state-owned enterprises and joint ventures, they aren’t required to deal with captive suppliers, so they can negotiate for the best deals. They also don’t have to pay licensing fees to foreign partners, since they don’t have any, and their chosen bases are second-tier cities, which have much lower labor costs. Overall, they manage their affairs with an entrepreneurial mind-set, which minimizes the bureaucratic overhead and waste seen in the joint ventures.

Taking down barriers

The success of these companies should encourage the Chinese government as it updates its automotive policy. The authorities can take several steps to promote the development of a powerful Chinese auto industry.

Barriers that discourage private and nonautomotive state-owned enterprises from entering the auto industry should be eliminated

For one thing, barriers that discourage private and nonautomotive state-owned enterprises from getting into the industry should be eliminated.¹ Unfortunately, the new policy would establish entry barriers, such as rules determining the minimum size of these companies. The government should also stop giving funds and preferential treatment to state-owned automakers and leave such decisions to commercial banks, which are gaining more and more autonomy. In short, the market should choose the winners. After all, private Chinese companies in other industries have already demonstrated that they have what it takes to succeed—for example, electronics goods makers TCL and Lenovo and the telecom-equipment producer Huawei Technologies—even though none of them was designated a key state enterprise.

As part of the move to eliminate entry barriers, the government should also drop the requirement that foreign automakers enter into joint ventures with local companies. Prolonging the joint-venture model serves no purpose other than subsidizing inefficient state enterprises. Moreover, both foreign and Chinese managers express frustration, publicly and privately, with the joint-venture arrangements—for example, the bureaucratic decision-making processes and the conflicts with shareholder interests—and wonder what would have happened if it had been possible to make business decisions freely.

Similarly, current joint-venture partners should be allowed to decide the future of their relationships: if they want to stay together, fine; otherwise, the partnership should be unwound. Foreign automakers would thus have greater freedom of choice in manufacturing and marketing. More important, this change would not only give nonincumbent Chinese companies new opportunities to gain access to technology by cooperating with foreign players but also strengthen the chances that some of the Chinese will emerge as local champions.

Government has a part to play

Although China should apply a market approach to the automotive industry, the government still has an important role to play in its evolution. It is essential, for example, to improve emissions and safety standards, including provisions for recalls. What’s more, by using profits from automotive joint ventures to finance selected R&D projects carried out by local manufacturers, China’s government can promote the development of the local industry’s technical prowess. These technologies could then be licensed to all local automakers and suppliers, which would otherwise find it too costly to invest in state-of-the-art emissions controls or fuel cells, for example.

The government can also ensure a supply of high-quality talent by encouraging private and public investment in universities and technical schools through income tax rebates, co-investment schemes with the state, and the provision of low-cost land. Such resources would help these institutions give students a professional education in automotive sales and marketing, engineering, and manufacturing. Furthermore, the government should sponsor consumer reports on the quality of Chinese-made vehicles and insist on greater transparency in the financial and operating reports of all major automakers.

The spectacular growth of China’s automotive industry over the past few years has hidden several important weaknesses. If policy makers continue to ignore them, the ability of the Chinese automotive industry to thrive, domestically and internationally, may be compromised. The government can play a key role in steering the development of the local automotive industry in the right direction.