China's leaders must rethink auto policy

China's automotive industry faces two critical challenges: substantial overcapacity and a massive proliferation of automotive companies and brands. Both challenges are structural but self-inflicted.

If China is to continue to have a profitable and sustainable automotive sector, it needs to rebalance the industry, and current policy needs to be re-examined to allow for consolidation, failure or other market-based dynamics.

Three years ago, China passed the United States to become the world leader in light-vehicle sales. Since then, China has extended its lead.

But despite that success, China's auto sector will undergo a stress test in the near future.

China's economy -- the engine that has driven its automotive industry to record heights -- is growing at the slowest pace in several years. As new-vehicle sales are slowing, factory and dealer inventories are rising and retail vehicle prices are falling. Consider this: In the first half of 2012, nearly half of the auto dealers in China reported they were unprofitable, compared with just 9 percent in the first half of 2010.

But slower vehicle sales are not the biggest challenge facing China's automotive industry. Sales of new light vehicles -- passenger vehicles and light trucks -- are expected to reach 19.2 million units this year, up 8 percent from 2011. While this is not the double-digit growth that China regularly experienced in recent years, it is still robust given the size of the market.

The first challenge is overcapacity. The country has the ability to build an astounding 28.5 million light vehicles annually, or roughly 9 million units more than the market is able to absorb in 2012. More unsettling is that another 10 million units of capacity are expected to be added within six to seven years.

The second challenge is the inordinately high number of competitors. Beijing's original auto industry blueprint was to create only four to six large Chinese automakers, thus guaranteeing sales volume and scale for its hand-picked competitors. But that is not how the story has played out. Instead, many provinces in China, recognizing the economic benefits of having their own automotive industrial base, have put their substantial financial and political support behind developing their own local industries.

Consequently, China's automotive market today plays host to 95 automotive brands, or than more than double the number offered in the United States.

Of that total, Chinese domestic automakers control about 48 brands, and those domestic brands typically account for about one-third of passenger-vehicle sales.

In 2012, that means that China's domestic brands will average about 95,000 sales each, a paltry number by industry standards and certainly too few sales to achieve the scale needed to sustain current operations or finance future growth.

Clearly, too many brands are chasing too few customers in China. The financial and political patronage of China's provincial benefactors allows many automakers to operate at artificially low levels of profitability (or at a loss), which in turn drives down retail prices and harms the entire industry.

Another issue facing the industry is the requirement that all foreign automotive companies that produce vehicles in China have a domestic joint-venture partner, with the local partner controlling at least 50 percent of the joint venture.

Each partner contributes staff to manage operations at the venture, and all decisions require both partners' approval. Naturally, that arrangement creates inefficiencies that are more difficult to compensate for as the market slows.

Moreover, if a foreign automaker wants to expand operations in China, often that company must form a new joint venture with a different Chinese partner -- one that may be a competitor to its original partner. The second joint venture creates redundant manufacturing and distribution channels to sell products that in traditional markets would be combined to optimize efficiency.

If pure market forces were in play in China, many domestic automakers would have closed or joined with competitors and many foreign automakers would have consolidated operations to achieve greater scale. Yet with jobs, revenue and long-term political influence in play, this situation could continue for some time.