The long road ahead: China’s changing automotive landscape

January 2023

Key Points

  • Led by Tesla, a new generation of electric vehicle brands is transforming Chinese consumers’ idea of what cars should be
  • Electrification allows suppliers from the consumer electronic and home appliance industries to compete in the global auto sector
  • Chinese semiconductor and software providers have a chance to grow their international market share

All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.

Being a leading global car manufacturer demands the kind of knowledge that takes years to build and prove. China has been striving towards this for decades.

The country’s automotive industry is much younger than those of more developed countries in Europe, the US and Japan. Significant car production here dates back only to the reformist 1980s and the landmark joint venture agreements between state-owned automotive groups and giant global brands.

In 1984 the establishment of Shanghai Volkswagen marked the beginning of the Chinese government’s effort to 'exchange market for technologies' – opening the domestic market to foreign players in the hope they would share production knowhow.

But it didn’t work as planned. The following decades saw only the manufacture and assembly of low value-add parts being outsourced to Chinese companies.

Meanwhile, Beijing imposed strict policies to protect these local companies. State-owned enterprises may have held majority ownership, but they developed only limited technological capabilities and remained heavily reliant on their foreign partners’ supply chains.

Despite these limitations, by 2008 China had emerged as the largest car market in the world, accounting for about a third of the global passenger car sales thanks to rising disposable income.

China’s new rich loved flashing their wealth behind the wheel of the latest luxury model, making the country one of the most profitable markets for global brands.

State support – breaking into the supply chain

The introduction of state subsidies for electric vehicles (EVs) in 2009 hoped to reposition China’s auto industry and strategically reduce the nation’s long-term carbon emissions.

These were largely focused on incentivising EV production and reducing total cost of ownership, including purchasing, charging and maintenance costs.

Tesla was the first non-Chinese brand to be eligible after its Shanghai Gigafactory opened in 2019.

Due to its lucrative market potential and agile supplier base, China presented the perfect opportunity for Tesla. According to the carmaker, the Gigafactory was approximately 65 per cent cheaper to build than its Model 3 production system in the US. It is big enough to produce 750,000 vehicles annually, with capacity expected to increase.

The media has been keen to stress how the Chinese government gave billions of dollars’ worth of cheap land, loans, tax breaks and subsidies to Tesla. With hindsight, the impact of this was deeper than is usually assumed.

Initially, state subsidies were widely perceived as a measure designed to protect local companies’ competitiveness. But the opening of Tesla’s Shanghai factory demonstrated the government’s efforts to attract an influential foreign company to the EV sector.

This was meant to improve market openness, prompt innovation from domestic competitors and attract the interest of the global capital market. Following on from this, other global EV brands became eligible for Chinese subsidies as well.

And despite the controversy surrounding more than a decade of substantial state support, this undeniably presented an opportunity for new Chinese automotive suppliers to build their product and cost competitiveness in the industry.

Electrification of cars replaces traditional internal combustion engines with a simpler mechanism that includes batteries and electric motors. The performance of the batteries is particularly sensitive to temperature, so they require thermal management systems.

Tesla’s Shanghai Gigafactory aimed to source at least 90 per cent of these parts locally.

It was a milestone project, offering the chance of a lifetime to many providers of equipment and components in China’s established home appliance and smartphone industries. Through the Tesla relationship, many were able to prove themselves to other global automotive brands.

Thus, a generation of suppliers grew up alongside their automotive clients. And as brands often prefer to keep their supply chain simple, these relationships have tended to last. 

Baillie Gifford has held thermal management component manufacturer Sanhua since the launch of its A-share portfolio, and battery maker CATL, as both had previously proved themselves in the German auto supply chain. After Tesla localised its manufacturing in China, they became its first Chinese suppliers.  

The rise of CATL has nurtured China’s battery supply chain, which now includes the world’s largest EV battery equipment supplier, Wuxi Lead Intelligent, and separator maker, Yunnan New Energy.

These suppliers possess part of the technical expertise behind the car-making process, optimising cost, safety and performance with their own capabilities.

Envisioning the future – from electrification to AI

Tesla is of course not the first company to sell electric cars in China. But it is the first brand to have changed Chinese consumers’ perceptions. Its pioneering engineering of vehicle infrastructure has also encouraged more creativity in the industry.

Chinese consumers have a reputation for adapting to new product concepts and lifestyles quickly, and EVs fit this pattern.

Tesla’s marketing appealed particularly to the younger generation, which suddenly saw EVs as a cool and practical alternative to fossil fuel vehicles. Locally-sourced parts helped to make the brand more affordable.

Several domestic car brands, including BYD, NIO and Li Auto are riding the trend and emerging as an attractive choice for local consumers, who have in the past preferred mid- to high-end German brands.

© Xinhua/Shutterstock

This may mark the beginning of more Chinese names establishing themselves in the top tier of the market – not just new EV companies but also domestic brands that had previously only been able to sell to the lower end of the market.

And interest in futuristic EVs is encouraging further innovation – artificial intelligence is likely to become a key element of user experience and vehicle performance.

Built on the foundation of the modern consumer electronics industry, the automotive brands, semiconductor and software industries are working more closely than ever to enable cars to become ‘computers on wheels’, with software that can upgrade continuously.

Under the influence of new brands, consumers are beginning to share this vision. 

It’s no exaggeration to describe this aspect of the supply chain as a battleground for global talent. But with its huge potential market size and favourable industry environment, China stands a better chance of attracting skilled individuals to help its brands increase market influence.

As well as those who have previously worked on automotive software, engineers from the smartphone industry may be brought in to work on user interface, while experts from internet companies might work on autonomous driving.

The huge talent pool from the consumer software industry could help Chinese automotive brands to come up with globally competitive products.

Semiconductors are the basic building block of any AI application. And Chinese car chip companies have already begun to break into this sector. The primary driver of their success has been the global shortage of ‘mature-node’ semiconductors – an older generation of chips that Chinese foundries can make – which emerged in 2020.

During the shortage, a few Chinese chip companies which historically supplied other industries passed the automotive-grade certification process to win contracts from global brands.

Most of these companies, which do not have their own manufacturing capacity, are still largely reliant on TSMC, the Taiwan-headquartered foundry that’s arguably the world’s most advanced chip maker.

But state-owned producer Hua Hong has also benefited by leveraging its specialism in power semiconductors, which are used to change voltages and frequencies. The demand for such semiconductors, which improve energy efficiency, has been increasing.

A window of opportunity

It is easy to see why fossil fuel vehicle brands could face an innovator’s dilemma.

Traditional vehicles are sold like hardware. Once delivered to the customers, their parts never need to be upgraded. But the expectation of frequent software upgrades from modern drivers conflicts with the traditional layered supply chain structure of the automotive industry.

Automotive brands will likely need to build a greater level of inhouse software and service capabilities to manage the competitiveness of their products. This could damage relationships with their long-term suppliers.

Traditional brands inevitably need to consider potential cannibalisation of their existing fossil fuel businesses and whether a new investment in AI-enhanced EVs could increase returns and provide jobs for long-standing employees.

When sales are relatively small, it is easy to conclude that the amount of investment needed to build a new battery EV platform is too high to be justified. Companies must therefore be sufficiently well financed, long-term and confident to make such a decision.

Consumer vehicle market competition will be a marathon, not a sprint. Trends move quickly and every year demand for new and innovative car models will be up for grabs.

As the Chinese saying goes, opportunities favour the prepared. The window to rebuild the supply chain won’t be open for long.

This presents a challenge. It takes time for new entrants to prove their capabilities and product durability before their qualities become recognised by the wider global industry.

Part of our task at Baillie Gifford is to try to spot certainties in a sea of uncertainties.

Chinese automotive companies and suppliers are undeniably more competitive than they were in the fossil fuel era – not just domestically, but globally.

With an established base in Shanghai and knowledge of investing in technological progress, Baillie Gifford has the advantage of on-the-ground expertise.

Our job is to make use of this position and identify the long-term winners arising from China’s changing supplier status quo.

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The views expressed should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.

This communication was produced and approved in December 2022 and has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.

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